If you can’t pay the tax on the return, you’ll escape collection action if you keep a low profile by not filing the return.

I hear it repeatedly, each year, year after year.  And it’s wrong, over and over.

Wrong on four counts

First, I’ve seen no evidence that the IRS leaps immediately to chase taxpayers whose filed return shows an unpaid liability.  In fact there’s a right to an installment agreement if your unpaid tax is $5,000 or less.

Second,  failing to file the return on time triggers a tax penalty separate from the penalty for not paying on time.  There are two penalties in play here:  a penalty for not filing and a different penalty for not paying.

Third, duck the requirement to file, and somehow you’ve given yourself permission to keep putting it off.  And of course, now that you are late, you have penalties added to the liability and the interest clock is ticking.

But most importantly to a bankruptcy lawyer is that you cannot ever discharge the tax debt in bankruptcy if the return is not filed.

Discharging tax in bankruptcy

Bankruptcy law sorts tax debts into three piles:

1. taxes secured by a lien
2. taxes that survive a bankruptcy
3. taxes dischargeable without payment

If you’ve got tax troubles, you obviously want your obligations to fall in that third pile, the dischargeable taxes.  Care to guess what the factor that determines dischargeability?  The length of time the return has been on file.

The rule, simplified a bit, is:  taxes are dischargeable in bankruptcy if they relate to a tax year whose return was due more than three years before bankruptcy; for which the return, if not filed on time, has been on file for two years; and the taxes for that year were assessed more than 240 days before filing.

So, you can’t begin to consider wiping out tax debt if you don’t file the return and that return needs a certain degree of aging before discharge is possible.

Bankruptcy is not the first choice of ways to resolve tax troubles, but bankruptcy can eliminate tax debt if it comes to that.

But not if you follow the myth that you don’t file the return until you can pay the tax.

Image courtesy of wikimedia.org

I’ve always assumed that California law excluded from income debt forgiven in bankruptcy, just as federal tax law does.

When a client asked me to confirm that the treatment was the same, I realized that this was one of those things I had just assumed.? As a lawyer, I ought to know the danger present in “assume”.

So I looked it up.? Bingo.? California Revenue & Taxation Code 17131 includes IRC? ?108 among the federal provisions that are the same in California tax law.? (There are too few of those places where the two are the same, for my tastes.? But that’s another rant.)

Cancellation of debt income is one of those gotcha’s that lurk, undiscussed, in debt settlement arrangements.? The tax system treats the forgiveness or cancellation of an obligation to be the same as if you had received the amount forgiven in cash!? It’s taxable income, unless you qualify for one of the exceptions.

Bankruptcy is an exception to the rule that debt cancelled equals taxable income. Debt discharged in bankruptcy is eliminated “in a Title 11 case.”

CAUTION California law on exclusion of debt forgiven in a foreclosure of a home IS NOT exactly the same as federal law.? At minimum, the amounts of cancelled debt differ.? Get tax advice from an experienced tax professional.? Asking your realtor is not good enough.

Image courtesy of YIM Hafiz

It’s not the foreclosing creditor that really threaten California homeowners.? It’s the forces that follow, the junior lender and the tax man who can deliver the truly punishing blows to a family losing a home.

Cut-off Junior Lienholders

Californians enjoy the protection of the one action rule governing foreclosures.? It says that a creditor who conducts a non judicial foreclosure of its security interest cannot collect anything more than the property it forecloses on.

Foreclosure is, as lawyers say, an election of remedies.? When the lender chooses to foreclose, it gives up the right to pursue the borrower for anything more.

But, the typical foreclosure sale destroys all liens on the property that are junior to the foreclosing creditor.? The HELOC lender, the second deed of trust, the SBA loan are rendered unsecured by the sale.? Unless the junior lien was created as part of the purchase of the property, the cut off junior lienholder CAN sue you for what’s owed on the debt.? The limitation on purchase money lenders suing you personally is often called the “antideficiency” statute.

So, if foreclosure is in the cards, you need to have a plan for dealing with the other players who no longer have a lien on the real property.? There’s a four year statute of limitations on collection actions, so the problem doesn’t go away quickly.

Cancellation of Debt Income

The tax code provides the second blow in these unhappy circumstances:? debt that is forgiven may be treated as if it were cash received by the borrower whose debt is satisfied for less than was owed.

In an era of falling home prices, homeowners more often receive a 1099 following the foreclosure sale that reports the difference between the fair market value of the property foreclosed and the amount of the debt owed to the foreclosing creditor.? Unless you fall into one of the exceptions found on IRS Form 982, the difference between those two numbers is reported as income on your tax return.

There is? temporary relief? from federal income tax through 2012 if the property foreclosed was the owner’s principal residence to the extent the loan was used to buy the property.? Relief under state law varies.

Impact of Bankruptcy Filing

A bankruptcy filing before a foreclosure sale eliminates both the liability to the junior lien holders and the possibility of tax liability on forgiven debt.? Tax law provides that debts forgiven in bankruptcy don’t generate cancellation of debt income;? a bankruptcy discharge wipes out any exposure to suit by the cut off junior lien holders.

It’s worth noting that a short sale may expose the homeowner to cancellation of debt income.? California law now requires that lien holders who consent to a short sale waive their rights to sue….so forgiveness of the debt is mandated.

Facing foreclosure is a stressful time, but it pays to look at the possibilities for collateral damage before you resign yourself to going through foreclosure.

In the tug o war of which creditor to pay, why is it that credit cards win over taxes and child support?

I’m accustomed to clients who pay creditors rather than provide for their own health care, emergency fund, or retirement.? That’s taking care of commitments to others before self.

But I haven’t figured out why embattled debtors choose to pay the credit card collectors instead of child support and taxes.? Yet that was just what this week’s client had done:? $10,000 in taxes and $24,000 in support for a child went unpaid, while he chipped away at credit card debt.

To a bankruptcy lawyer, this is insane, since both family support and recent income taxes are priority claims, not dischargeable in bankruptcy.? To an outsider, it’s still insane, since the IRS can simply take all the money in your bank account, without suing you first.? And your child is dependent and yours, not to mention that failure to pay child support is the one debt that can get you jailed.? Those are the creditors to fear.

I have two theories of why people choose to pay credit cards instead of taxes or support.

1. Terror of the Telephone: the credit card companies call, and call, and call if you don’t pay.? They invade your personal space at home, and they confront you with your financial shortcomings incessantly.? It’s hard on the nerves and the ego.
2. Credit Report Obsession: fixated on credit reports and credit scores, clients focus on the immediate “damage” that credit card delinquencies can inflict, and set aside the more lasting damage that tax liens and wage intercepts can cause if you ignore the feds and the child support authorities.

Credit card companies can’t take your money without suing you first, so they have to use fear and shame to get you to distort priorities and pay them first.

We need to get that word out.

Image licensed under Creative Commons, courtesy of Javier Kohen.

The last time I wrote about cancellation of debt and the possible tax surprise on foreclosure or short sale, I couldn’t lay my hands on the form the IRS provides to calculate insolvency. Found it!

IRS publication 4681 contains the worksheet along with an explanation of the application of the principal that, absent an exception, debt cancelled without payment is just like cash in the bank.

My life is simplified because debt discharged in bankruptcy generates no tax consequences to the borrower.

See earlier post on cancelled debts, and the tax consequences of foreclosure.

Image courtesy of danielmoyle.

Be prepared with answers when clients ask:

• Should I try for a short sale?
• What does this 1099 mean?
• Are there tax consequences of a loan modification?

Bill Purdy, tax professor and real estate law practitioner, will discuss recourse and non recourse debt and the tax consequences of foreclosure.? The workshop runs 2 hours and MCLE credit is available. Advance sign up is required.

The program will be available later electronically. ? If you want to be notified when the electronic version is ready, send an email to cathy@law-full.com.