Bankruptcy | robergtaxsolutions.com

In my last post I wrote about why debt forgiveness counts as income, but I didn’t explain how to report it on your tax return. And it’s important that you do report it, or you’ll be getting a nice little letter from the IRS asking you why you didn’t.

First and foremost, if you received a 1099C for cancellation of debt on mortgage interest, you should be reading a different post. See: http://robergtaxsolutions.com/2011/11/what-you-need-to-know-if-your-mortgage-debt-is-forgiven/ What I’m talking about here is cancellation of credit card debt. It doesn’t get treated in exactly the same way as mortgage interest.

Generally, if you receive a 1099C statement, I think you should see a tax professional—and make sure it’s someone who’s worked on debt cancellation issues before. Not everybody does that. I once had a client who had called around and I was the 5^th person he called before he found someone with debt cancellation experience. He had started at one of those big box tax places and was told that he owed the IRS $14,000. That’s when he started thinking he wanted a second opinion. When I did the return, he actually had a refund.

To be fair, his case was unusual and he managed to catch all the breaks in the tax code—but if he didn’t have someone who knew the tax code and where the breaks were—well then he would have been paying $14,000 in income taxes that he didn’t really owe.

So how do you report income from cancellation of debt? Basically, it goes on line 21 of your tax return, in the other income category. It gets taxed just like anything else that goes on that line—at your regular income tax rate. That’s what happened with the $14,000 fellow—his preparer put his 1099C income on line 21. While that’s the correct way to report 1099C income, she had neglected to look for exceptions to see if some (or all) of it might not be taxable.

The two most common exceptions to having your 1099C income being taxed are bankruptcy and insolvency. In bankruptcy, you’ve actually filed for bankruptcy and your case is either under the jurisdiction of the court and the court has granted a discharge of indebtedness—or is under a plan approved by the court. Bottom line—you’ve got the legal paperwork to back up your claim that you should be exempt from tax on your cancelled debt.

With insolvency—it means that your liabilities exceeded the fair market value of your assets immediately before the discharge. Okay, in English. Let’s say you owed $10,000 on a credit card—that’s a liability. Your assets included a car, some clothes, a TV, a little cash in the bank that the value of all that totaled $7,000. Since your liabilities (the $10,000) are more than your assets (the $7,000) you are insolvent by $3,000. So if the credit card company discharged $5,000 of your debt, you would be able to exclude $3,000 from tax but you’d still pay tax on the $2,000 that you weren’t insolvent on.

To report an exclusion of cancelled debt from taxes, you’ll need to use Form 982. Here’s a link to that: http://www.irs.gov/pub/irs-pdf/f982.pdf

If you think you might qualify for the insolvency exclusion, you’ll want to fill out the worksheet located in publication 4681, it’s on page 6. http://www.irs.gov/pub/irs-pdf/p4681.pdf

Now to be perfectly honest, I’ve really oversimplified this for the sake of brevity. Many people will have cancelled debt and won’t qualify for any tax forgiveness. Also, it’s important that you don’t file for tax exclusions if you don’t qualify for them (it’s a type of fraud—you don’t want to go there.) And it’s quite possible that you can do everything right with the 982 form and you’ll still get a letter from the IRS asking you to confirm something. (That actually happens quite often so don’t be surprised—it’s pretty normal.)

There are two really important issues you need to learn from this blog post:

1099C income must be reported on your tax return
You may qualify for some type of exclusion so that some (or maybe even all) of it won’t be taxable

Photo by rubber bullets on flickr.com

This is one of the most difficult questions I get asked every year. I think most people have heard the 10% rule (donate 10% of your income to your church), but what they’re asking me is, “10% of gross, 10% of net after taxes, or 10% of net after my deductions?” And here’s my classic cop-out answer: “You should ask your religious leader.” I always thought that was safe, and different churches have different opinions. (Although I’ve never heard any religious organization say 10% after deductions – just to be clear.) I always thought that referring it back to the church was a good answer until one of my clients came back at me with, “I talked to my minister first and he told me to ask you.”

For a moment I was terrified. If I got this answer wrong, it’s not like a tax return mistake, it’s messing with God. Screw it up and you go to hell, go directly to hell, do not pass go, do not collect $200. And the reason it was so scary was because for this particular person, I felt that she could not even afford 10% of her net income to go to charity, much less 10% of her gross. (Hindsight being 20/20, I think her minister was pretty much thinking the same thing and didn’t want to make a rule that would harm his congregant.) If we used the 10% after deductions rule then nothing would be going to charity and that wasn’t an acceptable answer for my client. So we sat down and worked out a budget for her church donations. I figured that God wanted her to have a roof over her head and food on the table and we went from there. Her tithe didn’t work out to 10% of her income, but she was happy, I was happy, her minister was happy, and I didn’t get struck by lightning—a good sign.

So, how much should you tithe? If your church doesn’t have definitive rules on tithing, I think 10% of your take home pay is the best answer: ten percent into savings, ten percent into charity and the rest to handle your day to day living expenses. Now, if putting 10% into charity means you can’t put food on the table and maintain a roof over your head then we need to get you to a better financial place first. Donate what you can.

What if I don’t go to church? Even if you’re not donating to a religious institution, the idea of 10% going to charity is still a healthy one. There are thousands of worthwhile charitable organizations that need help. And, for many of us, we have friends or family members that need our charity just as much as the United Way or the ASPCA does. Remember, true charity isn’t always a “tax deductible” event.

If I tithe, what’s in it for me? For some people, charitable donations are tax deductible. That’s the obvious answer from a tax blog, right? But more importantly, I find that persons who regularly make charitable donations tend to weather the difficult economic times better. You could argue that’s because persons of faith have their faith to help them through hard times, and there’s certainly a lot of truth to that. But I also find that even people not associated with religious institutions who donate generously seem to fare better in difficult financial times than people who don’t contribute.

I heard someone suggest that it’s the discipline required to donate part of your income to charity that gives people the discipline to handle financial setbacks. I can’t say for sure. I do know that I prepare a lot of tax returns. I prepare a lot of tax returns for people going through bankruptcy and/or foreclosure. What I don’t see on those tax returns is charitable giving. Now you might say, “But, they’re going through bankruptcy, they have no money!” True, but the charitable giving isn’t there in the years before the bankruptcy either.

It’s only anecdotal evidence; I really don’t have hard numbers. I’ve talked with other tax people who’ve noticed the same thing. Perhaps the old adage is true, when you donate to charity, the person you’re helping the most may just be yourself.

Tag: Bankruptcy

How to Report Debt Forgiveness (1099C) on Your Tax Return

Charitable Donations: How Much Should You Tithe? Why Do It?