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Bankruptcy & Taxes

With the fluctuations in the housing market and overall economy, more people than ever are turning to bankruptcy to get out from under overwhelming debt.  Many in this position run straight to bankruptcy without considering the timing and affect on their taxes.  Here are some things you should know if you are thinking about filing for bankruptcy.

Filing for bankruptcy will not stop an audit, if it is already underway.  However it can stop collection action while the bankruptcy is pending.

Not all debt can be discharged in bankruptcy.  Certain priority items such as child support, student loans, or fines from criminal activities must be paid in full. When a Notice of Federal Tax Lien (NFTL) has been filed, the IRS enjoys the status of a secured creditor for those taxes. Since the lien attaches to all property owned by the debtor, the IRS can then collect the taxes from the debtor's property, whether it is exempt or nonexempt from bankruptcy.  Taxes that can be discharged in bankruptcy are personal income taxes that are at least 3 years old, counting from the due date including extensions.  The liability must have been assessed for 240 days, and if you did not file your tax returns those taxes cannot be discharged in bankruptcy.

In some situations it could be better to present an offer in compromise, which could result in debt forgiveness. Any debt forgiveness over $600 will be reported on a Form 1099-C. Some forgiveness of debt is considered taxable income, subject to certain exclusions.  Cancellation or forgiveness of debt will be excluded from income in bankruptcy cases and up to debtor insolvency.  A debtor is insolvent when the debtor's liabilities exceed the FMV of their assets.

If you are thinking about filing for bankruptcy make sure to include your lawyer and your CPA in the conversation. If you receive a 1099-C or engage in debt forgiveness and have questions about how much is considered taxable income, please consult your tax preparer.

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