Bankruptcy and It's Myths

Why Avoid Bankruptcy?

There was a time when bankruptcy was considered a last ditch effort to avoid paying your debts. Filing for bankruptcy was considered shameful, an admission that one could not manage one's personal finances.

Today, the stigma appears to have changed drastically. In fact, excessive credit card debt has driven many Americans to choose the bankruptcy route -- more than 1.8 million bankruptcy petitions were filed during the 2005 calendar year.

What Is Bankruptcy?

Bankruptcy was created to protect the financial health of the jobless and the infirm by eliminating high levels of debt.

There are two ways to file for bankruptcy, each with its own rules. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Bankruptcy Reform Act), made many changes in bankruptcy law.Under a Chapter 7 bankruptcy filing, many debts are eliminated, but the filer must liquidate personal assets to pay down some of the debt.

Personal property is sold by a bankruptcy trustee, who then uses the proceeds to pay creditors. Some assets are exempt if they are considered necessary to support the filer and any dependents, but state and federal laws vary widely.

In general, a percentage of home equity and disability benefits are exempt, and Chapter 7 filers may be allowed to keep any money or property they obtain after filing. Chapter 7 bankruptcy can be filed once every eight years.

A Chapter 13 filing does not erase debt. Rather, it requires the filer to set up a repayment plan, typically over a three- to five-year period, in exchange for keeping personal assets.

The Bankruptcy Reform Act of 2005 states that anyone with income above the state median will have to file for Chapter 13 and pay back at least a portion of their debts. In general, homes will only be protected if owned for at least 40 months. Chapter 13 bankruptcy can only be filed once every two years.

Certain debts cannot be erased under any bankruptcy filing, including alimony, child support, property settlements, criminal judgements and fines, student loans, and most taxes. In addition, a bankruptcy filing will not allow you to keep property that secures a loan, such as an automobile or home, unless you repay the loan.

Who Should File?

In general, filing for bankruptcy should be avoided. Filing, however, may help to begin a financial recovery if:

You cannot meet debt obligations on current income.

Attempts to negotiate payments with creditors have failed.

Your ratio of debt to annual income is 40% or more.

Previous attempts to reduce debt have failed, particularly with the help of a credit counselor or debt reduction plan.

You have charge-offs on your credit history. Charge-offs appear when you have debts that are more than 250 days past due that are written off by your creditors for accounting purposes. A series of charge-offs and bankruptcy are both black marks on your credit report, but a bankruptcy filing demonstrates that you have at least dealt with the debt. Source: National Institute for Consumer Education.

Drawbacks to Bankruptcy

A bankruptcy filing is a black mark on your credit history. This can make it difficult to obtain loans, mortgages, and credit cards. Both a Chapter 7 and a Chapter 13 bankruptcy will appear on your credit report for 10 years. During this time, you may be subject to several financial hardships.

Secured loans may be more expensive to acquire. Only a handful of lenders may approve you for mortgage and car loans. Acquiring a loan or mortgage may require an initial down payment of as much as 50%, and you may need to accept interest rates significantly higher than those offered to people with clean credit histories.

Unsecured loans may be impossible to acquire. Credit card companies typically reject applicants with bankruptcies on their credit histories. You may only be able to obtain a secured credit card, which requires a security deposit typically equal to the amount of credit initially granted. Fees for these cards are generally higher than for unsecured cards, and issuers may charge an application fee.

Not all retirement account assets are protected. Qualified retirement accounts, such as 401(k)s, are protected in all bankruptcy filings. And, up to $1 million in an individual retirement account is protected. Federal law requires that only those assets needed to support a filer and dependents are exempted, so you may only be able to keep a portion of an IRA account.

New legislation makes filing for bankruptcy more difficult. The Bankruptcy Reform Act of 2005 prohibits some people from filing for Chapter 7 bankruptcy; adds to the list of debts that people cannot get rid of in bankruptcy; makes it harder for people to come up with manageable repayment plans; and limits the protection from collection agencies for those who file for bankruptcy.

In addition, anyone filing for Chapter 7 or Chapter 13 must undergo credit counseling at their expense six months prior to filing for bankruptcy and will also be required to take a financial-management course after filing.

Alternatives to Bankruptcy

Bankruptcy, and the resulting credit difficulties, is not the only way to manage excessive debt.

You can try to negotiate a payment plan with a creditor and perhaps reduce your debt. Credit card companies faced with the rising number of bankruptcy filings may prefer to get some of what's owed them rather than have the entire debt erased.

You can conduct these negotiations on your own, with the help of an attorney, or through a professional credit counselor, who specializes in credit negotiations and will charge less than an attorney for the service. Payments for the negotiated debts can be deducted directly from your paycheck by the counseling service, which then distributes the money to creditors. Credit counselors will also work with you to rebuild your credit and improve your long-term financial situation.

Bankruptcy should still be seen as a last resort after all other methods of settling debt have been exhausted. The thought of your debt being erased may be attractive, but the financial hardships bankruptcy can create far outweigh any benefits.

Additional resources:

Declaring Bankruptcy

Bankruptcy Fraud - Criminal Investigation

New Bankruptcy Law Changes Debtor's Responsibilities

Avoiding the 1099 Cancelled Debt Trapp

The rate of debt charge-off and mortgage forgiveness has increased dramatically in 2007. If a federal government agency, financial institution, or credit union cancels or forgives a debt you owe of $ 600 or more, you will receive a Form 1099-C, Cancellation of Debt. A debt includes any indebtedness for which you are liable or which attaches to property you hold. The IRS mandates that you must claim this amount as income on your taxes because you never paid it back- thus making it income. However if you "settle" this debt as "paid in full" (i.e., credit cards payoffs) with the creditor make sure you ask that they agree to the settled in full arrangement and not send the remainder as a loss to the IRS. If the creditor willingly accepts "less than" as "full payment" then make sure they agree not to report remainder. The creditor can refuse but usually does not.

If any interest is forgiven and included in the amount of canceled debt in box 2, the amount of interest will also be shown in box 3. Whether or not you must include the interest portion of the canceled debt in your income depends on whether the interest would be deductible if you paid it.

Certain student loans contain a provision that all or part of the debt incurred to attend the qualified educational institution will be canceled if you work for a certain period of time in certain professions for any of a broad class of employers. You do not have income if your student loan is canceled after you agreed to this provision and then performed the services required.

An example of excluded debt which is not considered as canceled debt in your gross income includes anydebt is canceled in a bankruptcy case under title 11 of the U.S. Code. See Publication 908, Bankruptcy Tax Guide or if you are deemed insolvent. However, you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent.

Credit card industry facts and personal debt statistics (2006-2007):

Market share ranked by major card type: 1. Visa - 54 percent; 2. MasterCard – 29 percent; 3. American Express – 13 percent; 4. Discover Card – 4 percent (Source: Cardweb)

Did you know………..

• The first widely accepted plastic charge card was issued in 1958 by American Express.
• The first general use credit card that allowed balances to be paid over time was the BankAmericard (which later changed its name to Visa in 1977), issued in 1959 (Source: PBS Frontline; American Express, Visa USA)
  
• The average interest rate across all existing credit card accounts was 13.46 percent as of May 2007 (Source: Federal Reserve)
  
• There were 984 million bank-issued Visa and MasterCard credit card and debit card accounts in the U.S in 2006 (Source: Visa USA, MasterCard International)

Now let’s look at another example of a cancellation of debt, the dreaded 1099-A (Acquisition or Abandonment of Secured Property). Let’s say the bank foreclosed on your home in 2007. The resulting debt-forgiveness income was not exempt because you were not “insolvent or bankrupt”, then you must report the forgiveness as taxable income on your 2007 Form 1040. As a result you have a balance due on your 2007 Form 1040.

In reading the various tax blog discussions on the subject of home foreclosures and resulting debt forgiveness, tax law professor, Jim Maule of MAULED AGAIN provides an excellent description of the situation in his post “Greed, Stupidity. Poor Judgment and Taxes”; “The recent downturn in the housing market, a predictable and predicted outcome of the rampant speculation in housing fueled by speculators and gamblers bored with the stock market and looking for something more exciting, more profitable, or more instantaneous, has created serious financial problems for homeowners who overreached when purchasing or investing in residential real estate. Those problems include not only loss of the home through foreclosure but higher federal and state income tax liabilities because the foreclosure can generate cancellation of indebtedness income.”In simpler terms - families who wanted to buy a home that they could not afford found lenders willing to give them a mortgage with a minimal down payment, a low interest rate, and small monthly payments for an initial limited period (i.e. Adjustable Rate Mortgage). When this initial limited period passed and it was time to refinance the mortgage housing prices had dropped – so that the principal balance on the loan was more than the market value of the home – and interest rates had gone up. The overextended families could not afford the new monthly payments and the lenders had to foreclose on the properties.In many situations the borrowers and lenders reached agreements so that portions of the mortgage debt were “forgiven” by the lenders. This debt forgiveness can result in taxable income to the borrower. Here’s a very simplified example. You borrow $20,000 and default on the loan after paying back $5,000. If the lender is unable to collect the remaining debt from you and writes off the loan, there is a cancellation of debt of $15,000, which generally is taxable income to you.The proposed Mortgage Cancellation Tax Relief Act of 2007 would amend the tax code to forgive debt cancellations on primary residences and is currently before the House Ways and Means Committee, the primary tax legislation body of Congress. The bill would permanently exclude from tax liability any mortgage debt on a principal residence that is forgiven following a foreclosure or renegotiation with lenders – providing homeowners affected by the nationwide sub-prime mortgage crisis with $2 billion in tax relief.

Jim Maule has wisely pointed out that “The bottom line is that the proposed tax relief doesn’t prevent the foreclosure, doesn’t put the people back into their homes, and doesn’t do much to help them straighten out the mess that their lives have or will become because of the misguided decision to bite off more financial responsibilities than their means would permit them to chew.”Relief already exists for most of the lower-income taxpayers. Debt cancellation on foreclosure is not taxable to the extent that you are insolvent. That is, to the extent that your liabilities (the money you owe) exceeds the value of your assets (the value of what you own). For tax purposes you are considered insolvent if after reducing your total original liabilities by the amount of debt cancelled your total outstanding debts still exceed the value of your assets. .
You claim this relief on IRS Form 982(Reduction of Tax Attributes Due to Discharge of Indebtedness). All you have to do is check the box at Line 1(b) in Part I and indicate the amount of debt forgiveness that is exempt from federal income tax on Line 2. You attach the Form 982 to your Form 1040 for the year in which the debt has been cancelled. Although most Americans seem to be avoiding the credit card trap, they are not dodging the adjustable mortgage traps; there are still plenty of people on the financial edge.Consider these statistics:

• More than a third -- 36% -- of those who owe more than $10,000 on their cards have household incomes under $50,000, according to the VIP Forum analysis.
• 13% who owe that much have household incomes under $30,000. The percentage of disposable income used to pay debts is still near record highs.
• The median value of total outstanding debt owed by households rose 9.6% between 1998 and 2001.
• Bankruptcies set another record in 2003, with 1.6 million personal filings, the American Bankruptcy Institutereports.

All of that is more than enough evidence to suggest that a large number of people are overdosing on debt. An excellent example of relief from the stress of such financial burdens is to contact InCharge Debt Solutions (http://www.incharge.org), a nonprofit organization who is devoted to personal financial health. They provide professional credit counseling, education and resources to help those burdened with too much debt regain financial health without a loan or bankruptcy.

If you are concerned about the tax implications of a 1099-A or 1099-C, you may also be interested in speaking with IRS Tax Resolution firms such as Effectur, Inc. (www.effectur.com). Firms like these generally offer free telephone tax consultations.

Educate yourself and get the facts before you sign for that high interest credit card or adjustable rate mortgage loan. If you bite off more than you can chew or default, Uncle Sam will be waiting just around the corner to get his fair share.

SHARON RAINES

SR. TAX ADVISOR/PREPARER