Bankruptcy is simple, the hard part comes later. But when you’ve hit the end of the road in terms of your debts and other liabilities, you really should declare bankruptcy. Refusing to do so is like refusing to throw up when you’ve had too much to drink, it only makes things worse. So declare bankruptcy; learn from your mistakes, and then jump back on the horse. Also, read this article because you’ll learn about the basic tax consequences of bankruptcy.
Debt Cancellation
(I’ve touched on this topic before, here and here.)
The fist scenario that occurs frequently in bankruptcy is that some or all of your debt is cancelled. Generally, when debt is canceled, you don’t just get to walk away scot-free. Because you essentially received money that you never had to pay back, it’s classified as taxable income. If you have cancelled debt income due to bankruptcy, you’ll receive a Form 1099-C, Cancellation of Debt, with code A in box 6 to indicate bankruptcy.
There is an exception to the inclusion of canceled debt income due to bankruptcy for those in title 11 bankruptcy, whose details are beyond the scope of this article. However, if your case falls under title 11, then your income due to debt cancellation is excludable from gross income. Indicate this by including Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) with your return. Lines 1a and 2 apply to title 11 bankruptcy, so focus on those. Then, you’ll have to go down the list of tax attributes found in Part II of Form 982, from which you’ll reduce their values by the amount prescribed by law, as articulated below.
Reduction of Tax Attributes
The rest of this article will go through the tax attributes first mentioned above that have to be reduced in the event of exempt income from debt cancellation due to bankruptcy. These tax attributes are property, tax credits, and losses accumulated in the current tax year or prior years. I’ll just go through these one by one.
Qualified Principal Residence Indebtedness
This is your main home that you live in most of the time. If you have declared bankruptcy and you’re able to exclude income from the cancellation of debt stemming from your mortgage on that property, reduce the basis in your principal residence, assuming that you have held onto it.
Personal Use Property
If you don’t have any other property besides personal use property, meaning property not used in a trade or business, and you have excluded cancellation of debt income, then assuming that you have already reduced the basis in your primary residence to zero, you’ll have to reduce the basis in personal use property, such as jewelry, vehicles, and furniture. The amount you reduce the bases of these items is only the amount of the excess of aggregate basis in all personal use property over and above the amount of debt, both evaluated immediately after the cancellation of the debt in question. Attribute the amount reduced in each asset by the percentage the basis of that asset constitutes in relation to the total amount of basis right after cancellation.
Net Operating Loss
A net operating loss is a loss that occurs when you have a loss from your business that eclipses total revenue. In other words, you didn’t earn any positive profit from your business for the tax year; in fact, you lost money overall. These net operating losses are deductible in subsequent years after the year they occur, so they are useful to have around. However, if you go through bankruptcy, you have to reduce your net operating losses by the amount of excluded cancellation of debt income, but not below zero. Reduce net operating losses first before any other attributes.
General Business Credit Carryover
The general business credit is calculated on Form 3800, General Business Credit. This form is representative of an amalgam of credits that apply to businesses, such as the orphan drug credit, the low-income housing credit, and the disabled access credit, just to name a few. These credits are carried forward from tax year to tax year depending on when they can be used. Reduce the amount of your accumulated credits by 33 1/3 cents per dollar of excluded cancellation of debt income. Reduce general business credit carryover only after reduction in net operating losses.
Minimum Tax Credit
The minimum tax credit is figured on Form 8801, Credit for Prior Year Minimum Tax – Individuals, Estates, and Trusts. This is a credit you get for paying the alternative minimum tax, which as the name suggests imposes a minimum amount of tax for a given amount of income. This credit applies to tax items that were deferred from being taken in a tax year and allows credit to be given in subsequent years. Reduce the amount of your accumulated credits by 33 1/3 cents per dollar of excluded cancellation of debt income. Reduce your total minimum tax credit third after reduction in net operating losses and general business credit carryover.
Net Capital Loss and Capital Loss Carryovers
Net capital losses are overall losses from the sale or exchange of capital assets. These losses are carried forward if they eclipse a limit of deductibility in the tax year, currently $3,000 ($1,500 married filing separately). Reduce the amount of your net capital losses and capital loss carryovers by each dollar of excluded cancellation of debt income. Reduce your total net capital loss and capital loss carryovers after reduction in net operating losses, general business credit carryover, and minimum tax credit.
Basis
Basis is more or less what you paid for an asset, plus adjustments to that basis based on events that either increase or decrease it. You’ll have to reduce your basis in the following property in this order: 1) real property used in your trade or business; 2) personal property used in your trade or business; 3) any other business property; 4) inventory, accounts receivable, notes receivable, and real property held for sale to customers; 5) and personal use property, which has nothing to do with your business. Reduce the bases in these by one dollar for every dollar of excluded cancellation of debt income but only to the extent the bases of your property is greater than the amount of outstanding liabilities and debt right after the cancellation of debt income accrued. Reduce the bases in the foregoing assets after reduction in net operating losses, general business credit carryover, minimum tax credit, and net capital loss and capital loss carryovers.
Passive Activity Loss and Credit Carryovers
Passive activity losses are those losses generated by certain activities that are not materially participated in. Basically, it’s a loss derived from a business interest where you’re just a silent investor. Credit carryovers are, as they sound, unused portions of credits that are carried forward into future years where they can be used. You’ll have to reduce the passive activity losses on a one to basis by the amount of your exempt cancellation of debt income. You’ll also have to reduce your credit carryovers by 33 1/3 cents for each dollar of exempt cancellation of debt income. Reduce passive activity losses and credit carryovers after reduction in net operating losses, general business credit carryover, minimum tax credit, net capital loss and capital loss carryovers, and the bases in various assets.
Foreign Tax Credit
The foreign tax credit is available in compensation for paying taxes to a foreign government in an effort by the IRS not to double tax Americans’ incomes. It’s figured on Form 1116, Foreign Tax Credit. For each dollar of excluded cancellation of debt income you must reduce your foreign tax credit or foreign tax credit carryovers by 33 1/3 cents. Reduce passive activity losses and credit carryovers after reduction in net operating losses, general business credit carryover, minimum tax credit, net capital loss and capital loss carryovers, the bases in various assets, and passive activity loss and credit carryovers.
Conclusion
The gist of bankruptcy is that if you exclude income from the cancellation of debt you must reduce tax attributes by an amount prescribed by law, and memorialized by Form 982. If you are having issues with Form 982, or have any other tax problems or questions, don’t hesitate to call Dino Tax Co at (713) 397-4678 or email davie@dinotaxco.com. Your first phone consultation is always free. Also, like us on Facebook at www.facebook.com/dinotaxco.
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