There is nothing easy about making the decision to file for bankruptcy. I welcome the opportunity to speak with you personally and confidentially to help you find the ideal solution to your financial challenges.
Restructuring of debt involves a two-step analysis to determine whether a taxable event has occurred.
Were the terms of the debt modified?
Was the modification significant?
A “modification” means any alteration of a legal right or obligation of the issuer of the debt instrument. The modification can be within the terms of an existing debt or by the exchanging of one debt instrument for another.
Unlike simply possessing the “get out of jail free” card in the Monopoly game, getting out of debt tax free is much more complicated.
During the recent recession we have heard numerous reports involving homeowners that are upside down on their mortgage (the outstanding loan balance is more than the value of the home). This has led to an increase in debt restructuring activity, not only on residential mortgages but also on commercial loans, small business loans and even credit card debt.
Most debt restructuring transactions are in the form of restructuring of debt or outright forgiveness of the loan balance, this restructuring of debt can trigger adverse tax consequences. IRS regulations for debt modifications were issued under Sec. 1.1001-3 in 1996.
The second test includes five rules for addressing whether the “modification” is significant.
General Test – facts & circumstances.
Change in yield – interest rate reduction of 1/4% or greater, or 5% of the annual yield.
Change in timing of payments – extending the maturity date (beyond 5 years).
Change in obligor or security – release, substitute or alter a substantial amount of the collateral.
Changes in the nature of a debt instrument – recourse to non-recourse (and vice versa).
Restructuring of debt normally results in taxable income, but there are exceptions.
Under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million of debt forgiven on your principal residence during tax years 2007 through 2012. You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure. The debt must have been used to buy, build or substantially improve your principal residence and must also be secured by that residence. Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion
Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision. In some cases, however, other tax relief provisions – such as insolvency – may be applicable. IRS Code Sec. 108a provides relief provisions to debt discharge income in bankruptcy and insolvency situations.
– Bankrupt Taxpayers; these are taxpayers with debt discharged under the jurisdiction of a court in a Title 11 case (chapters 7, 11, 12 and 13 bankruptcies).
– Insolvent Taxpayers; these are taxpayers that have liabilities (debt) in excess of the fair market value of their assets. Taxable debt discharge income is excluded to the extent that their liabilities exceed the “FMV” of their assets. Any debt discharge income in excess of the “insolvency calculation” is reportable taxable income.
While bankrupt and insolvent taxpayers can exclude debt discharge income from taxable gross income, they must then reduce certain tax attributes (to the extent possible). This reduction in “tax attributes” may mean that eventually income will be recognized upon the sale of the property due to a reduced tax basis within the property.
The following tax attributes are reduced in debt discharge income situations:
Net operating losses
General business credits
Minimum tax credits
Capital loss carryovers
Tax Basis of the property
Passive Activity Loss & Credit carryovers
Foreign Tax Credit carryovers
The tax impact of debt forgiveness or cancellation and the rules relating to debt modifications are very complex and depend on your individual facts and circumstances. There is no “get out of debt free” card, so please contact your tax professional at Dermody, Burke & Brown to assist you.
The second test includes five rules for addressing whether the
“modification” is significant.
General Test – facts & circumstances.
Change in yield – interest rate reduction of 1/4% or greater, or
5% of the annual yield.
Change in timing of payments – extending the maturity date
(beyond 5 years).
Change in obligor or security – release, substitute or alter a
substantial amount of the collateral.
Changes in the nature of a debt instrument – recourse to
non-recourse (and vice versa).
The tax impact of restructuring of debt or cancellation of debt and the rules relating to debt modifications are very complex and depend on your individual facts and circumstances. There is no “get out of debt free” card, so please contact your tax professional at Dermody, Burke & Brown to assist you.
During such a time vendors may begin to settle your outstanding debts for less than the face value simply because you lack the cash to pay each amount in full. While you might be relieved of these debts, it is important to understand that the amount of debt that was canceled could be taxable, and the ability to free up cash to pay the tax while insolvent can prove very difficult.
Your eligibility for bankruptcy determines what type of bankruptcy you can file. There are two (2) types of personal bankruptcy filings; Chapter 7 and Chapter 13. If your debts are mostly consumer debts, then you will be eligible to file for a Chapter 7. This is by far the most common type of bankruptcy. Chapter 13 takes 3 – 5 years and instead of giving up property, you repay a portion of your debts and live within a strict budget that is monitored closely by the bankruptcy court trustee.
The “Means Test” is a mathematical formula that establishes your eligibility for bankruptcy and the type of bankruptcy you qualify for. If your median household income is less than the Nevada median income (currently $61,864), then you can file for a Chapter 7 bankruptcy. However, if according to the results of the formula, you have enough net monthly income to repay debts you are not eligible for Chapter 7 bankruptcy, but you may be eligible for relief in Chapter 13 bankruptcy.
If your income exceeds the Nevada median household income your eligibility for bankruptcy may still exist and all is not lost. You may have special circumstances that warrant a waiver of the “Means Test” formula. You will have to show that your expenses incurred are reasonable and that you have no practical alternative. Judges are given discretion to determine if special circumstances allow filing a Chapter 7 bankruptcy by a debtor who cannot pass the “Means Test” formula.
How The Means test works
The process to determine your eligibility for bankruptcy can be expensive and confusing, the means test clarifies whether you’re eligible for Chapter 7 bankruptcy or confined to Chapter 13.
The means test has two parts, both designed to see if you have any disposable income that you could put toward paying off debt and if your eligibility for bankruptcy. Generally, your bankruptcy attorney will fill out the form and submit it to the court with the rest of your filing papers.
The test is only for those who have primarily consumer debts, like credit card or medical debt; you don’t need to pass the means test if your debt is mainly from a business you own. For Chapter 13 bankruptcy, the test also plays a part in setting the repayment schedule.
The first part of the means test checks whether your household income is below your state’s median income.
While the means test is based on the past six months, there are adjustments for recent or upcoming changes. Say you had a job for four of the past six months but are now unemployed. The means test will factor in the drop in income. Conversely, if you recently got a new job and are making more money, that increase will be considered as well.
If you’re below the median income, you’ve passed the means test and can file for Chapter 7 bankruptcy. It’s as easy as that.
In fact, in 2013, all but 12% of debtors who took the means test passed it in the first stage, according to data from the Executive Office for U.S. Trustees, a government organization that oversees the administration of bankruptcies.
For people in that 12% who still hope to file for Chapter 7 — and for people who want to file for Chapter 13 — there’s a second part of the test.
Gather documentation to determine your eligibility for bankruptcy about your expenses over the past six months. Things such as rent, groceries, clothing and medical costs make up what are called “allowable expenses.” What’s left after allowable expenses is deemed disposable income that could be put toward paying off debt.
Be thorough. This is where you can make crucial mistakes, such as omitting items or listing conflicting amounts for the same expense, that could result in your case being thrown out.
“It can be a fairly involved process,” says California bankruptcy attorney Matthew Olson. “Other than what people tell me, I don’t know what’s going on with their family situation and expenses. There’s a fair amount of responsibility on consumers to be forthright with coming up with information.”
What’s allowable is based on both national and local standards used by the IRS. National standards cover items like food and clothing, while local standards cover expenses like housing and car payments. Your lawyer will work with you to ensure that you have your expenses properly documented.
If your disposable income is shown to be low enough, you may still qualify for Chapter 7 bankruptcy at this point.
If you’re filing for Chapter 13 bankruptcy, either because you can’t meet the test for Chapter 7 bankruptcy or you want to keep some of your assets, the allowable-expenses portion of the test will be used when working out the terms of your repayment plan.
If you pass the bankruptcy means test
Passing the means test gives you the green light to file for Chapter 7 bankruptcy, which will forgive most of your unsecured debts, like medical bills and credit card debt. But that doesn’t mean that’s the best route for you.
You might be better off filing for Chapter 13 bankruptcy. This type of bankruptcy allows you to get caught up on your debts — such as a mortgage, overdue loans and back taxes — and hold onto your assets, says Melissa Davey, member at Stites & Harbison, a creditor rights and bankruptcy services group in Georgia.
“Most often debtors choose Chapter 13 because it allows them to propose a plan to restructure debt,” Davey says. Talk with your bankruptcy attorney to figure out which solution is best for your situation and goals.
If you fail the means test
There is no appeals process if you fail the means test, but that doesn’t mean Chapter 13 is your only option, provided you can hold off on filing for a while.
Remember, the income and expenses you use to fill out the means test reflect your financial situation for the past six months. You can take the test again after six months if you think your situation then will meet the threshold for Chapter 7 debt forgiveness.
If you can’t wait any longer to file for bankruptcy and can’t pass the means test, you’ll be restricted to a Chapter 13 and will pay back your debts over three to five years.
Portrait of Stephen R. Harris, Esq. local Nevada bankruptcy lawyer. He has been providing financial protection and debt-relief for 46 years.
At Harris Law we have been providing financial protection and guidance in the Reno area for the last 46 years. Bankruptcy may not be your only option. Let’s explore all of the alternatives and possibilities that could exist for you.
Let me work with you. Please call 775-786-7600 to make an appointment for your free, confidential and personal consultation to talk things over.