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Can Filing Bankruptcy Protect Me From A 1099-C Tax Obligation?

We received another great listener question. The simple answer is yes, filing bankruptcy before a foreclosure sale or short sale will protect you from a subsequent 1099-C assuming the bank waives any deficiency.

Before we get there, however, some background:

When someone gets foreclosed or completes a short sale, there are one of three ways that the bank will treat the deficiency – the difference between what is owed and what the bank received from the foreclosure or short sale: (1) the bank will try to pursue its deficiency, (2) the bank will try to collect its deficiency by some long term or settled agreement or payment plan, or (3) the bank will waive its deficiency.

If the bank chooses to waive the deficiency, then you receive a benefit – that you do not have to pay back money that is contractually owed to the bank. The IRS call this “Forgiveness of Debt Income” and treats it as ordinary income. This income often called “phantom income” because you get no money in your pocket. This income is reported by the lender on IRS Form 1099-C. For example, years ago, my student loan company offered to waive $5,000 of my student loan debt if I paid for 2 years consistently. At the end of the two years, my debt was reduced by $5,000 and I received an IRS Form 1099-C in the mail showing I had an additional $5,000 in income for that year.

One misconception is that the bank can choose to waive the 1099-C. This is false. The bank MUST issue a 1099-C if the forgiveness of debt is more than $600.

Back to the question: You can use IRS Form 982 to report to the IRS that 1099-C income is non-taxable for a variety of reasons. One of those reasons is that the underlying debt was discharged in a case under Title 11 of the United States Code. Title 11 of the US Code is where the bankruptcy laws are published. While I am not a tax attorney nor CPA and am unable to give tax advice, it is my assumption that for the bankruptcy to effectively eliminate the phantom income, the bankruptcy must be filed before the phantom income is created – i.e. before the foreclosure or short sale is completed.

For more information on whether the phantom income is taxable, please consult a CPA or Tax Attorney. We can make recommendations if you live in the Tampa Bay Area. For more information on foreclosures and short sales, please subscribe to the Crushing Debt Podcast, on iTunes, Stitcher and GooglePlay. If you prefer, please contact us to schedule a free initial consultation to discuss your options at 813-774-5737 or email me directly at shawn@yesnerlaw.com.

Shawn M. Yesner, Esq., is the host of the Crushing Debt Podcast and founder of Yesner Law, P.L., a Tampa-based boutique real estate and consumer law firm that helps clients eliminate the financial bullies in their lives. We assist clients with asset protection, the sale and purchase of real property, Chapter 7 liquidation, Chapter 13 reorganization, bankruptcy, foreclosure defense, debt settlement, landlord/tenant issues, short sales, and loan modifications in Tampa, Westchase, Odessa, Oldsmar, Palm Harbor, Clearwater, Pinellas Park, Largo, St. Petersburg, and throughout the greater Tampa Bay area.

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