Bankruptcy and CODI
All bankruptcy falls under USC Title 11. There is also a bankruptcy Chapter 11. This similarity causes a lot of confusion. Since we are mainly dealing with personal tax returns, we will not deal with the Chapter 11 bankruptcy in this course. We will be talking about Chapter 7 and Chapter 13 of the Title 11 Code.
Chapter 7 is the “discharge” chapter. In a Chapter 7 bankruptcy all included debts are theoretically discharged. If there are assets secured by those debts the assets are usually forfeit. The Deemed Sales and CODI rules apply in those cases.
The debtor may protect some property from the claims of creditors because it is exempt under federal bankruptcy law or under the laws of the debtor’s home state.
In many states, the debtor has the option of choosing between a federal package of exemptions or the exemptions available under state law.
Typical exempt assets a debtor may choose to exclude are items such as:
• Debtor’s home (different values are excludible in different states)
• Cars (basic transportation)
• Household furnishings
• Tools of trade (limited amounts)
• Limited amounts of jewelry, computers, and electronics
• Retirement funds including IRAs
Basis reductions for CODI using the bankruptcy exclusion, do not reduce the basis in property that the debtor treats as exempt property. This property was never a part of the bankruptcy estate, so no basis reduction will be applied to these assets.
Exempt property’s eligibility for bankruptcy exclusion – Most exempt assets qualify for the bankruptcy exclusion, but in some cases some debts are intentionally not included in the bankruptcy.
In order to use the bankruptcy exclusion, the debt had to be discharged by the bankruptcy court, and therefore had to be included in the bankruptcy. If debt that was not included in the petition is later discharged, the resulting CODI is not eligible for the Bankruptcy Exclusion, because the debt was not canceled by the bankruptcy court. However, that does not mean the debt may not be eligible for one of the other exclusions or exceptions.
Later foreclosure reported on debtor’s individual return – After the bankruptcy discharge, the lender can foreclose on the property but cannot get a deficiency judgment for any shortage.
Debtor can keep property – The debtor may continue to make payments on the debt and keep the property, if he chooses, since the property was not a part of the bankruptcy estate.
CODI on abandoned property is eligible for bankruptcy exclusion – CODI income resulting from the discharge of debt on abandoned property (that is later foreclosed or on which the loan is later modified) does qualify for the Bankruptcy Exclusion, because the court made the debt unenforceable.
Discharge – A discharge releases debtors from personal liability for most debts. After the discharge of the bankruptcy petition, any remaining tax attributes return to the debtor.
Debtor’s reduction of tax attributes – If, after the bankruptcy, a debtor excludes CODI on debt that was made unenforceable in a bankruptcy case, they must reduce tax attributes by the excluded amount. This only applies if the property was not forfeit in the bankruptcy. Remember, reduction of attributes takes place based on the debtors holdings on 1/1 of the year following the year of the CODI.