Sometimes bankruptcy can be used to get rid of older income taxes, but did you know it could be used to avoid future income taxes? It can if you get very good and timely advice on how to do that if the situation pertains to you.
To understand, you must first acquaint yourself with two concepts: “gross income” (“GI”) and “cancellation of debt” (“COD”). Gross income is the giant intake at the head of the tax hopper. It broadly includes everything that could possibly be taxable. Its inclusions and exclusions are codified in Internal Revenue Code Section 108. Among its inclusions are COD income.
This COD income is sometimes called “phantom income” because it may have never actually arrived in your bank account. However, according the IRS, you derived a benefit from it, ergo it is income.
One example to illustrate where the IRS has a definite point is where someone owns a company but does not take a salary. Instead the company gives them money as a loan. Later the company, owned by the same individual, forgives the loan, so the debt is canceled. Now that is obviously income disguised as a loan.
The same logic is applied to COD from mortgages as well. Let’s say you owned a commercial property that you rented out to a business. Now that business failed and moved out and you cannot find a tenant to move in and pay anywhere near the same rent, and the new market rent will not cover the mortgage payment. Additionally, you overpaid for the property during the boom and now it is worth far less than you paid for it (say $300,000 less), so you cannot sell it either. You stop paying the mortgage and let the bank foreclose. The following year, or maybe two or three years later the foreclosing bank issues you a 1099C for COD. Now the IRS has notice that you received $300,000 of debt forgiveness. You are in a marginal 1/3 tax bracket so that income has you owing the IRS $100,000.
IRC 108 has an exception inclusion of two things in GI; insolvency and bankruptcy. Your CPA can either prove you were insolvent when the COD occurred, which is subject to interpretation, or you could have filed bankruptcy and had the debt discharged before the COD occurred. The fact of bankruptcy is indisputable, whereas your insolvency is an argument your CPA makes and may wind up in tax court.
For now and the next few years homeowners do not have to worry about this COD tax problem if the house is worth less than $2 million because there is a temporary federal law that excepts personal residences from this type of tax obligation. Hitting homeowners for taxes after they have lost their home in foreclosure would be politically unpalatable, and literally millions of Americans are in this category now. The $2 million dollar ceiling helps prevent even well heeled homeowners who are losing their home, which can occur here in Long Beach, or elsewhere in Los Angeles and Orange Counties.
It is important to get the right advice when you’re in a defensive posture in your finances. These are complicated webs that we find ourselves in and getting the right advice can make the difference between solving problems or creating more problems.