If suddenly faced with potentially tens of thousands of dollars of IRS debt, filing bankruptcy is an incentive that might not be considered otherwise.
For a decade prior to 2018, individuals who had mortgage debt forgiven or canceled because they lost their primary residence through a foreclosure or a short sale could exclude up to $2 million of that amount from their taxable income.
The provision expired at the end of 2017, along with dozens of other temporary tax breaks. And now with Congress’s attention to end-of-the-year priorities, the likelihood of renewing those tax perks in the near term is fading.
Taxpayers can potentially turn to tax relief under other parts of the tax code. Individuals who are insolvent -they have proved to the IRS that their liabilities exceed the value of their assets—or are in bankruptcy can exclude canceled debt from their taxable income. That can prevent them from having to pay taxes on tens of thousands of dollars in additional income, maybe more.
Taxpayers will have to consider whether the tax savings outweigh the negatives. In bankruptcy, for example, individuals risk losing certain “non-exempt” assets that the court can sell to pay back creditors.
Timing is another important factor. Individuals should file for bankruptcy before tax is assessed because there are limitations and more complicated rules for discharging tax debts according to Geoffry Walsh, a staff attorney at the National Consumer Law Center. This opportunity may have already passed for taxpayers with canceled or forgiven mortgage debt who had tax assessed in 2018.
Walsh noted that in bankruptcy individuals discharge more than just the debts associated with their mortgage. So they could have other types of debt—credit card debt, medical debt, etc.—that they may have otherwise found a way to pay if it weren’t for the massive tax bill on their forgiven mortgage debt, he said.
Renewing the tax break would be better for taxpayers, the court system, and the IRS than killing it permanently and pushing people into bankruptcies that otherwise wouldn’t happen, said Julia Gordon, president of the National Community Stabilization Trust, which works to restore vacant and abandoned properties.