Florida Bankruptcy Law Blog

Another Tax Trap From Short Sale or Deed in Lieu

I saw an email about income tax liability associated with foreclosure or bankruptcy sent by attorney Larry Heinkel. The email addresses income tax liability from the foreclosure of properties which have previously been depreciated for tax purposes. Most people know that if a bank forgives part of a mortgage loan in the course of a short sale or deed in lieu that the amount of debt forgiveness may be taxable if the mortgaged property is an investment or second home. A new law has eliminated debt forgiveness tax for principal residences. A person who is insolvent at time of short sale or deed in lieu, or who files bankruptcy, has no liability for debt forgiveness taxation. Mr. Heinkel points out a different tax trap.

If the debtor has previously depreciated the property for income tax purposes the tax basis of the property has been lowered from its original purchase price. The short sale or deed in lieu may be treated as a "sale or exchange" which triggers income tax on the difference between the property value and the adjusted basis. This tax liability is not eliminated by insolvency or bankruptcy. People considering walking away from investment property should check with their CPA to see if they may incur tax liability by the recapture of prior tax depreciation.

posted by Jonathan Alper, bankruptcy and asset protection attorney, Orlando, Florida

Is Payment To Parents' Corporation A Preference To An Insider

Within six months of filing Chapter 7 bankruptcy a debtor paid back a $10,000 loan from his parents by taking a cash advance on a credit card. In fact, the parents made the loan from a business checking account from their wholly owned family business. The general rule is that the bankruptcy trustee can avoid repayments of loans to family members or other insiders within one year of the bankruptcy petition. The debtors asked whether the bankruptcy trustee could go after their parents for receipt of the loan repayment and whether their credit card company could go after them for borrowing $10,000 shortly before filing bankruptcy when they had no ability or expectation of repayment.

The loan repayment was not directly to the parents, but to a business. The Bankruptcy Code defines insiders to include relatives of the debtor such as a parent. The definition does not seem to include as an insider a corporation or other business entity owned by a relative. The trustee could argue that the repayment to the parents’ corporation was made indirectly for the benefit of the parents or that the corporation is the parents’ alter ego. The debtor’s intent was clearly to prefer the parents at the expense of other creditors.

The loan from the credit card company was similar to a balance transfer where debtors use one credit card to pay off another card. Balance transfers most often are not problematic because the debtor has not acquired property nor benefitted other than adjustment of interest rates. This transaction is somewhat different than a balance transfer among credit cards because the motivation was not an adjustment in payments or interest. The credit card company may assert that the money was borrowed in contemplation of bankruptcy to make a payment indirectly to the debtor’s family.

posted by Jonathan Alper, bankruptcy and asset protection attorney, Orlando, Florida

Childrens' Trust in Chapter 7 Bankruptcy

Parents establish an irrevocable trust for the benefit of their children and primarily for educational purposes. The parents serve as trustees. One of the children has special needs. Family friends want to help the parents out financially. Rather than give the parents money, the friend contribute money to the trust. Soon after the friends contribute money to the childrens’ trust the parents file Chapter 7 bankruptcy. The parents asked me whether any part of the trust could be claimed by the bankruptcy trustee.

Based on these facts, and assuming the trust has standard form language, I do not think any part of the trust is subject to the trustee or other creditors. The parents have stated a valid reason for creating an irrevocable trust other than shielding money from creditors. Recent contributions to the trust by friends are not fraudulent transfers because the transfers were by people other than the debtors. The parents’ control over the trust as trustees does not make the trust assets their property as long as the parents are not potential income or principal beneficiaries.

posted by Jonathan Alper, bankruptcy and asset protection attorney, Orlando, Florida

New Law Eliminates Income Tax Liablity For Some Short Sales

Previous posts on this blog have discussed income tax risk associated with giving banks a deed in lieu of foreclosure or arrangements for a short sale. The general rule is that foregiveness of debt, including a bank's waiving mortgage deficiency liability, is taxable income. Last month, December, 2007, Congress passed a bill to relieve many homeowners from income tax liability associated with deeds in lieu, short sales, or foreclosure. The Mortgage Forgiveness Debt Relief Act of 2007 states that homeowners will not be subject to income tax from release from mortgages used to buy or improve their primary residence. Link: GovTrack: H.R. 3648: Text of Legislation.

The Act exempts up to $2,000,000 of debt forgiveness for married couples. Yet, not everyone is eligible for this income tax shelter. There are time limits on this legislation. The Act applies to debt forgiveness from residential mortgages from January, 2008 through December, 2009.

Only relief from mortgages on primary residences is tax protected. A debtor can still be taxed from a deed in lieu, short sale, or a foreclosure on an investment property, second home, or a business mortgage. Also, many debtors took second mortgages on their homes during the housing bubble to pay off and consolidate credit card debts. Mortgage companies often required borrowers to pay off all credit card debt with finance proceeds in order to increase their ability to pay their home mortgages. Any portion of forgiven mortgage debt used to pay credit card debts will still be subject to taxation.

Debtors whose mortgages do not qualify for this legislative relief may still escape debt forgiveness taxation by filing bankruptcy prior to the foreclosure or by filing IRS forms declaring their insolvency at the time of foreclosure.

Another interesting comment on this new law was posted by Oregon attorney Kent Anderson on the Bankruptcy Law Network Blog Link: Home Loan Foreclosure No Longer a Tax Trap? : Bankruptcy Law Network.

posted by Jonathan Alper, bankruptcy and asset protection attorney, Orlando, Florida

U.S.Trustee Seminar Helps Clarify Means Test Exemptions

The U.S. Trustee’s office in Orlando held a seminar to discuss their application of the Means Test. Among many interesting topics were the characterization of debts as either consumer debts or business debts. The distinction is important to determine if a prospective Chapter 7 debtor is exempt from the means test. If a debtor’s debts are primarily non-consumer debts the debtor is eligible to file Chapter 7 regardless of whether he passes the means test.

I frequently meet debtor’s who moved from an expensive home into a less expensive house as their principal residence. They rent the expensive house and use the rental income to pay the mortgage. The question is whether the mortgage on the expensive home is a business debt because it is rented at time of filing bankruptcy or a consumer debt because the mortgage was taken to purchase a primary residence for personal use. The Trustee’s position is that a house formerly occupied but currently rented will be a non-consumer debt if the debtor shows the mortgage was treated as business debt on a prior income tax return.

After taking out a first mortgage to purchase a residence some debtors use a second mortgage to finance their own business. When the proceeds from a second mortgage are used mostly to pay business expenses the second mortgage is a non-consumer debt for means test purposes.

Similarly, if a debtor’s obligation to a particular credit card company had been incurred primarily to pay business, or other non-consumer expenses the balance owed to that credit card company is non-consumer debt. The Trustee’s position is that the entire credit card balance is non-consumer debt and not just those charges used to pay non-consumer expenses.

posted by Jonathan Alper, bankruptcy and asset protection attorney, Orlando, Florida

Chapter 13: Stripping Away Second Mortgage

I occasionally get valuable tips from other bankruptcy attorneys who read this blog. Ben Stolz, Esq. recently referred me to this article about stripping away unsecured second mortgages in Chapter 13 bankruptcy cases. Link: Second and Third Mortgages Mean You Have No Equity? The Benefits of a Chapter 13 Filing! : Bankruptcy Law Network.

The article, written by a bankruptcy attorney,  discusses bankruptcy tool for people with first and second mortgages who want to use Chapter 13 bankruptcy to save their homes from foreclosure. When there is sufficient value in the property to justify keeping the first mortgage, but not also a second mortgage, the author says that the debtors can strip away the second mortgage while keeping the first mortgage intact. The debtors have to proof to the bankruptcy judge that the current value of the property is not greater than the first mortgage balance.

Did Transfer of IRA Proceeds Lose Protection Prior to Bankruptcy?

A prospective Chapter 7 bankruptcy client told me he had recently withdrawn substantial money from his IRA and had given the money to his adult son. The client intended to buy a house to be used as his new homestead, but he had bad credit. The son had good credit. The client gave the IRA money to his son so that the son could qualify to buy the house in the son’s name. Subsequently, the son would transfer title to the parents. The client withdrew the IRA proceeds and deposited the money in his own account before transferring the same money by written check to the son. The issue was whether the money in the son’s account is protected if the parent files bankruptcy. Was the transfer of the money to the son a fraudulent transfer?

This is one of those situations where innocent planning error could undermine valid substantive planning. The IRA was exempt from creditors and the bankruptcy trustee under Florida statutes. The IRA statutes do not expressly protect proceeds from IRA or other qualified pensions; in contrast, the statutes expressly protect annuity proceeds. There are some court decisions which hold that the legislature intended to protect the proceeds of retirement accounts, but the law is not clear.

There can be no fraudulent transfer of an exempt asset by definition. If the client transferred the money directly from the IRA account into the son’s financial account I do not think any creditor could attack the transfer as fraudulent if the transfer was a gift to the son. But, when the creditor withdrew the IRA money and deposited into his own financial account the money may have lost its exempt status because the IRA was converted into a normal bank account in the client’s own name. The subsequent transfer to the son could at least be challenged as a fraudulent transfer. .

Whether the transfer to the son is a fraudulent transfer depends on the parties’ intent. The client would argue that the intent clearly was to give the son exempt money from the IRA as a gift. A bankruptcy trustee might argue that the transfer was to the son, not as a gift, but to the son as a nominee or alter-ego of the debtor because the son was going to use the money to by a house for the debtor’s exclusive personal use. The money would be non-exempt at least until the new homestead was purchased and occupied. Like most fraudulent transfer issues, this situation depends on the particular facts and the testimony of the participants. This plan could have worked without challenge with more careful asset protection planning.

posted by Jonathan Alper, bankruptcy and asset protection attorney, Orlando, Florida