Bankruptcy and the IRS

Picture of Stephen Dunne, Esq.

Stephen Dunne, Esq.

Philadelphia bankruptcy, credit report, and debt collection abuse attorney

How do taxes and bankruptcy work together?
Picture of Stephen Dunne, Esq.

Stephen Dunne, Esq.

Philadelphia bankruptcy, credit report, and debt collection abuse attorney

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Why are taxes so confusing? It seems like every answer generates three more questions.

I’ll tackle a few general answers to common issues here, but always get personal advice from a professional on any tax matter.

What if I can’t pay off my tax debt in five years under Chapter 13?

The rule is that priority debts (which include taxes) must be paid in full in Chapter 13. Sometimes, that number is impossible to pay off within the five-year limit of a Chapter 13 repayment plan.

  1. If you find yourself in that situation, consider an “offer in compromise” to the IRS.
  2. The IRS is empowered to negotiate your tax debt with you.

You can base your offer in compromise on one of these two issues:

  • You question whether you really owe this tax debt; and
  • You can’t afford to pay what you owe.

To determine what standards the IRS uses to calculate allowable housing and living expenses to evaluate your offer in compromise, you can visit this directory.

If your tax debt is non-dischargeable because it is too recent, consider waiting a while longer to file bankruptcy if you can. The older income tax debts get, the more likely they are to be dischargeable.

Do I have to pay taxes if I’m foreclosed on?

Possibly. You could face two kinds of tax liabilities after foreclosure:  capital gains tax and cancellation of debt tax.

Capital Gains Tax

It doesn’t matter whether you voluntarily sold your house or got foreclosed on; the IRS treats it the same way when it comes to capital gains. The amount of capital gains depends on the property’s tax basis, whether it was your residence, etc.

If you file bankruptcy, the timing of your foreclosure matters when it comes to capital gains taxes. If the foreclosure occurs before you file bankruptcy, then you are responsible. If the foreclosure occurs after your bankruptcy filing, provided the property is part of the bankruptcy estate, any tax consequences are included in the bankruptcy discharge.

If you know you’re going to lose the property anyway, your choice of timing could prevent you from having to pay taxes on the money you didn’t even receive.

Cancellation of Debt Tax

If any part of your debts is canceled or “forgiven” outside of your bankruptcy, then the dollar amount of the forgiven debt counts as income to you in that year. This means the cancellation of debt tax isn’t a separate tax, per se – it’s just an increased income tax liability, which is the last thing you need when you’re trying to clean up your financial house.

Does the IRS need to sign off on my Chapter 13 repayment plan?

In Chapter 13, the IRS is just another creditor, and its available grounds for objection are the same as any other creditor has.

Typically, the IRS is happy to see your Chapter 13 filing because they know they get paid in full without having to do more work to collect on the debt.

What about any tax liens that survive Chapter 7?

A Chapter 7 discharge eliminates your personal liability for the tax year(s) that go with your lien, although the in-rem lien is still attached to the equity in your property. Fortunately, the in-rem lien cannot attach to assets you acquire after your bankruptcy case is filed.

Regarding the lien, your choices after discharge are:

  1. You can pay the IRS the total equity value of the assets they attached at the beginning of your case (in essence, “buy back” your equity).
  2. You can do nothing, if your collateral has little value or is exempt by law from being levied, in the hopes the IRS won’t attempt to enforce the lien.
  3. You can file Chapter 13 bankruptcy to pay the lien over time if it is attached to valuable assets.

Can the bankruptcy court settle a dispute between the taxing agency and me?

Yes, it can. The bankruptcy court has the power to decide between a creditor and a debtor. Remember I said above that the IRS is just another creditor in the eyes of the bankruptcy court.

If you file a no-asset Chapter 7, since there will be no payments made to creditors, the bankruptcy court holds no interest in resolving disputes about non-dischargeable tax debts.

By contrast, if you file Chapter 13, since payments are always made to creditors, the bankruptcy court will have a need to decide disputed claims. Therefore, filing Chapter 13 might be the fastest, least expensive way to get a fair ruling on a tax dispute.

Where can I get advice on how bankruptcy might affect my tax situation?

An experienced bankruptcy attorney can help you lay out a strategy. It’s free to chat with me about your options – you can call or text me at 215.551.7109, or drop me a line.

Let's go over how I can help. Our first chat is on me.

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