Cancellation of Debt, Taxes, and Insolvency

[womanonfire]

This is probably an advanced topic but I'm wondering if in certain instances, like in mine where I'm currently insolvent, have home equity, an inheritance coming in an undetermined amount, and a settlement in a lawsuit in an undetermined amount, could it possibly beneficial from a tax standpoint to settle inside of bankruptcy rather than outside?

For instance, I have claims against mortgage servicer and owner that I can bring in federal court now and perhaps settle those claims for a cash award or debt forgiveness (modification, reformation of contract) or I could bring those claims as defenses in recoupment in bankruptcy and have the debt reduced that way. I think the difference is the tax liability.

I'm looking at this specifically: 26 U.S.C. § §108. Income from discharge of indebtedness

(a) Exclusion from gross income

(1) In general
Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

(A) the discharge occurs in a title 11 case,

(B) the discharge occurs when the taxpayer is insolvent,

(C) the indebtedness discharged is qualified farm indebtedness,

(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or

(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged—

(i) before January 1, 2021, or

(ii) subject to an arrangement that is entered into and evidenced in writing before January 1, 2021.

Many people may not know this but if you win a lawsuit, you have to pay taxes on the entire amount, including the attorney fee or contingency fee as well. So if you're attorney recovers $25,000 for you and his fees are $50,000, you must pay taxes on $75,000. This doesn't always apply to some personal injury and employment cases.

In my case, timing is everything. Also interested to see what comes of debt forgiveness in upcoming modifications (think HAMP.) Because sometime in 2015, debt forgiveness in a loan modification is considered cancellation of debt income.

Thoughts?

[joshuagraham]

If you are receiving an inheritance (i.e., that someone has already died), then you are not insolvent until that gets zeroed out.

When I was doing my Chapter 7, I was a plaintiff in a class-action lawsuit (that ended up being worthless, well after the BK case closed) at the time. I simply mentioned it to the trustee, and he didn't bother doing anything about it.

[womanonfire]

If you are receiving an inheritance (i.e., that someone has already died), then you are not insolvent until that gets zeroed out.

When I was doing my Chapter 7, I was a plaintiff in a class-action lawsuit (that ended up being worthless, well after the BK case closed) at the time. I simply mentioned it to the trustee, and he didn't bother doing anything about it.

I'm looking at my balance sheet with all my debt and assets including home equity on it PLUS inheritance and I'm still showing my liabilities are greater than my assets.

[justbroke]

womanonfire proving insolvency, for purposes of IRS Form 892 (Reduction of Tax Attributes) is much easier with a bankruptcy under Title 11, then probably trying to prove it for purposes of reducing the tax impact of an IRS Form 1099-C (Forgiveness of Debt). I will always say that bankruptcy is only way to have finality when it comes to debt, liabilities to pay the debt, and any tax implications from having the debt forgiven (Form 1099-C) or discharged.

As you mention, there were special programs created after the housing crisis of 2008. Some of those programs ended in 2016 and included programs such as TARP, HARP, HAMP and special debt considerations for tax liability as you also mentioned.

You're right, though, this is an advanced tax issue if you don't plan to file bankruptcy. If you're not going to file bankruptcy, and have significant equity, un-liquidated damages in a lawsuit, and/or other windfalls (not excluding inheritance), then the strategy is likely best discussed with a tax accountant, enrolled agent, or tax attorney as that's an entirely different ball of wax. I say that because I know the finality of bankruptcy. When you're at the mercy of the tax code, that's entirely different game.

Whether or not the proceeds of a lawsuit are taxable, depends on the nature of the proceeds. Proceeds from a class-action lawsuit are almost always worthless when it's a large class. I've been paid in many class-action lawsuits and have received as little as $10, a free year of credit monitoring, all the way up to $3,000 from some Bank of America issue during the housing crisis. Hardly anything a Chapter 7 trustee would want to wait for. But, a personal injury lawsuit is an entirely different beast.