What do do when creditors send you a 1099 for debts you discharged in bankruptcy

Sometimes when people have debts discharged in bankruptcy, their creditors send them a 1099 showing the discharged debt as income. I have noticed that many accountants do not know that this is NOT income pursuant to federal law. 26 United States Code Section 108(A) (1) excludes from income debts that are discharged by bankruptcy. It also excludes debts that were forgiven by the creditors, in whole or in part, to the extent the person was insolvent. I constantly see clients with tax returns showing large amounts owed to the IRS or Virginia Department of Taxation after a bankrutpcy discharge for "forgiven debts." These are not forgiven debts. They are discharged debts, and they are NOT TAXABLE. If you have any questions about whether or not your should pay taxes on these kind of debts, ask a bankruptcy attorney, not an accountant. Apparently, many of them are not aware of the law and give incorrect advice.

What are schedules I and J in a bankruptcy petition

If you pass the Means Test, the next question is whether you qualify under Schedules I (Income) and J (Expenses). Schedules I and J measure your actual income and expenses but totally disregard any expenses you will get rid of in the bankruptcy. All income counts. Child support counts. Social Security income counts. Unemployment income counts (but not in the means test). Profits you make from your business count but not the gross income of the business. All income counts. Not all expenses count.

 You are not allowed to have too high a budget for discretionary items like recreation. You can tithe up to 10% of your income to churches or give it to charities. Your grocery bill on Schedule J is often less than it actually is. Clothing expenses are limited. What isn’t limited are medical expenses, health insurance, car insurance, and other necessities. Most people actually have more expenses than income to cover them when Schedules I and J are done.

You also want to look at the assets you are allowed to keep to see what you may have to give up to your creditors. Most people can exempt everything they own but check my website at www.marilynsolomonlaw.com to see a list of items you are allowed to keep in Virginia and West Virginia.

Also, remember bankruptcy consultations are free at the Law Firm of Marilyn Solomon.

What is the Means Test to qualify for bankruptcy?

When the bankruptcy law was totally revised in 2005, a new requirement called "the means test" was added to it. The Means Test is supposed to measure the average income in each state. The debtor's income is compared to the "mean" or "average" state income. If your income is less than the mean income in your state, you qualify to file a Chapter 7 bankruptcy under the law assuming you meet other requirements. If your income is more, than you must take "part two" of the means test.

Part two of the Means Test calculates your particular allowable expenses including priority expenses like child and spousal support and taxes, your secured debt like the debts against your house, car, or furniture, and other expenses like health insurance and medical expenses then determines if you have any money left over to pay your creditors. Basic living expenses are filled in for you depending on the city or county you live in and are based on what the IRS thinks it cost, not what it actually cost. The second part of the Means Test is, thus, partly hypothetical.

If you have no money left over to pay creditors, you qualify. If you do have money left over, you have to file Chapter 13. Many people pay enough for health insurance or medical expenses or support that they qualify even with a very high income.

As it happens, some people have money left over under the second part of the means test but do no actually earn enough money to qualify for Chapter 13 because the means test does not use all of your actual living expenses and for some of your expenses, it substitutes hypothetical ones. It assigns expenses to you based on where you live except for priority and medical expenses. Many people are trapped in the middle and thus have no bankruptcy option available to them. They make too much for Chapter 7 and not enough for Chapter 13.

The good news for Virginia is that the Means Test here is about the third highest in the nation as all the high wage earners in Northern Virginia pull up the average income for everyone. Right now, a family of one (just you) can make up to almost $50,000 and a family of four can earn up to about $86,000. These numbers change every month or two and, because of the economy, have gone down a time or two as well.

If you make more than the mean amount, it is still worth inquiring about Chapter 7 as you may pass part two of the means test and be eligible anyway.

How to avoid foreclosure

A lot of clients ask me what to do to stop a foreclosure on their home. There are several options that may be available: deed in lieu of foreclosure, modification of the loan, or short sale. Here is the difference.

Usually, a deed in lieu of foreclosure can only be done when there is only one mortgage on your home. If you have a second mortgage, equity line, or judgment or tax lien, it is usually not possible to do a deed in lieu. How this works is the mortgage company takes back the house instead of foreclosing on the house. They wipe out any deficiency between the value of the house and the amount owed on the loan. The bank keeps the house, and the homeowner can walk away with no debt owed to them.

A short sale means the homeowner puts the house on the market for sale and sells it. It is more difficult to do a short sale when you have more than one loan because all the lien holders have to agree to do the short sale and how to divide up the money received. You need to receive permission from the bank to do a short sale. Most of them require a “hardship letter” to qualify which means you need to explain why you hare having a hard time and the bank gets to decide if your reason qualifies. The most commonly accepted reasons are medical expenses, job lay offs, and divorce but the bank considers many problems as hardships. They appraise the house to get an idea of how much to sell it for. The house is sold for less than is owed on the mortgage (you sell it “short” of your loan amount). The bank forgives the difference.

Another option is refinancing. Many homeowners cannot refinance because their house is upside down or underwater (you owe more on it than it is worth). Sometimes the bank will cooperate any way but, again, if you have more than one mortgage this is probably not an option for you unless you can refinance the amount you owe to both. There are some federal programs around to assist homeowners but they have very particular qualifications and you have to make every payment on time if they decide to give you a chance. Most consider these programs to be failures, but some people have successfully refinanced with them. Some of those programs are:

Homeowner Affordability and Stability Plan (HASP) also known as the Making Home Affordable Plan (MHAP)

Home Affordable Modification Program (HAMP)

Home Affordable Refinance Program (HARP)

Hope for Homeowners (H4H)

A new program to help with second mortgages (second lien, home equity loans) has just started too.

Home Equity Loan Modification (HELM)

Here is a good website for more information on the federal programs available

http://trackthestimulus.com/Home_Equity_Loan_Modification.aspx