Filing for bankruptcy is a scary, yet often necessary process for people who are struggling with overwhelming debt. However, while bankruptcy can provide relief from creditors and even foreclosure, it can have significant federal tax consequences. Here are some things you need to know about bankruptcy and tax returns.
Bankruptcy and Tax Returns: 4 Key Things to Know
1. Separate Taxable Estates
When you file for bankruptcy, the first step of the process is to see whether or not the court accepts your petition. If so, the court will then create what's known as a bankruptcy estate. This estate will be the keeper of your assets, so to speak. Any assets that you have that are not exempt from creditors by law will be accounted for in this estate and will be overseen by a trustee. The trustee not only keeps track of your tangible assets, he or she is responsible for ensuring that you file your tax returns on time.
You don’t have to file a separate return for the bankruptcy estate. Your regular tax return is fine.
Regardless of which chapter you file, you will have to complete and file a Form 1040. In the event that you have had debt that a creditor has forgiven, say in a settlement arrangement where the creditor has chosen to accept a lesser amount, you will need to file a Form 982 on the amount you didn't have to pay. The Form 982 will inform the IRS that you have had a portion of your debt forgiven and may help you reduce your tax burden. If you are filing a chapter 7 or chapter 11 bankruptcy, the trustee will also file a Form 1041 for the bankruptcy estate. This will not occur under chapters 12 and chapter 13 bankruptcy since the estate isn't taxable.
It is important to understand the implications that filing bankruptcy will have on your ability to receive a federal tax refund. In every case, the processing of your form 1040 will be delayed because bankruptcy delays the processing of this form. Depending on the state in which you live, you will most likely forfeit all of your refund to the bankruptcy courts in order to satisfy debt although some states have laws that may allow you to keep a portion of your tax refund in certain circumstances.
4. Discharge of Tax Debt
Contrary to popular belief, some tax debts can be discharged through bankruptcy court. Federal income tax can be discharged as long as the tax debt is at least three years old at the time your bankruptcy petition is accepted and you filed on time for that year. In addition, you must not have committed fraud or tax evasion concerning that tax debt. Your bankruptcy attorney will be able to advise you further on this situation.
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