You received a 1099 after Bankruptcy Discharge: Now What?

By:  Steven P. Taylor, Law Office of Steven P, Taylor, PC

This time of year I will get a large amount of calls from my bankruptcy clients regarding 1099s and wanting to know if they will owe taxes as a result.  The answer is probably not, but maybe.  Generally, you can potentially receive either a 1099-A or a 1099-C from a creditor after you receive a bankruptcy discharge.  You should not receive a 1099-C, which is a cancellation of debt return.  You should not, but you might anyway.  

What is a 1099-A:  Relating to the acquisition of property by a lender,  Form 1099-A DOES NOT mean you have cancellation of debt (“COD”) tax.   Say the bank bid their judgment at the sheriff sale and became the owner of your house, either before or after filing a bankruptcy,  you will receive a copy of a 1099-A.  Form 1099-A is a form the mortgage company is required to file to show that they acquired your property.  It’s what the IRS calls an informational return–it just gives information to the IRS.  It tells the IRS the principal outstanding on the loan and the amount (presumptively the fair market value) for which the lender acquired the property back (in partial or whole satisfaction of the debt that was owed).    Again, all it means is that the part or all of the debt has been satisfied with the acquisition of property.

Tax Treatment:  The amount for which the lender acquired the property back is treated as a sale.   The 1099-A can potentially lead to capital gains tax.  For example, Debtor has rental property that has a basis of $50,000.00.  Debtor lets the property go in a bankruptcy , get a discharge and receives a 1099-A asserting FMV of $100,000 and debt of $150,000.  The excess of the debt over the FMV is cancellation of debt income that will be reflected in a 1099-C down the road probably (see below).  The sale of the property for $100,000 realizes a gain over the basis ($50,000) of $50,000 which is taxable.  Note that if the property was the principal residence of the Debtor, the capital gain may not be taxable under  Mortgage Debt Relief Act of 2007. (Now expired effective 12/31/2013) or depending on the holding period ($250k/$500K)

What is a 1099-C:  The issuance of a Form 1099-C means that some amount of  debt has been cancelled and is taxable income unless excludible. So what do you do?  Well, IRS Regulations require you to report the cancellation of debt, whether or not it is ultimately taxable. To exclude the cancellation of debt income from taxable income, you must file IRS Form 982.  Will you owe tax?  Well, if the debt was:

1.   was discharged in bankruptcy; or

2.    was incurred to purchase, construct or substantially improve your principal residence. This is the result of the Mortgage Debt Relief Act of 2007. (Now expired effective 12/31/2013); or

3.  If you were “balance sheet insolvent” at the time of the cancelation of the debt. Balance sheet insolvent is very simple: If the value of your obligations is greater then the value of your assets (including IRAs) you are “balance sheet insolvent.”  The trick here is to create a paper trail so that when the IRS comes a-knocking on an audit a couple of years from now, you will be able to demonstrate that insolvency,

Then you will not owe any ordinary income tax liability. 

Tax Treatment:  If you get a 1099-C and fail to include it in your tax return , the IRS may later write to you and say, hey, you owe us more $$$  because of the debt cancellation.    If you get that letter from the IRS, you need to write them back and say this debt was discharged in bankruptcy.  Send them a copy of your papers and  send  IRS Form 982.  Check the very first box, 1a.  Title 11 means “bankruptcy.”

Last Note:  My practice is limited to bankruptcy issues and the above information is general only (within my experience) and is not meant to constitute legal or tax advice appropriate for your situation. In addition, this information is subject to change and is not guaranteed accurate. Before you make a move with regard to these matters, visit the IRS website or contact your CPA for the latest 1099-C tax information and for help with your specific tax situation.