A chapter 13 bankruptcy is often called a “wage earner’s” bankruptcy. It enables individuals with regular income to develop a plan to repay all or part of their debts over three to five years. During this time the law forbids creditors from starting or continuing collection efforts.
Advantages – A particular advantage of chapter 13 is that it provides debtors with an opportunity to save their homes from foreclosure by allowing them to “catch up” past due payments through a payment plan.
Effect on collections – Individuals may use a chapter 13 proceeding to save their home from foreclosure. The automatic stay stops the foreclosure proceeding as soon as the individual files the chapter 13 petition. The individual may then bring the past-due payments current over a reasonable period of time.
The debtor may still lose the home if he or she fails to make the regular mortgage payments that come due after the chapter 13 filing. In that case the normal CODI and deemed sales reporting rules apply.
Discharge – A chapter 13 debtor is entitled to a discharge upon completion of all payments under the chapter 13 plan. The discharge in a chapter 13 case is somewhat broader than in a chapter 7 case. Debts dischargeable in a chapter 13, but not in chapter 7, include debts for willful and malicious injury to property, debts incurred to pay nondischargeable tax obligations, and debts arising from property settlements in divorce or separation proceedings.
Tax effect – When a debtor files for reorganization under Chapter 13, no separate bankruptcy estate is created. The taxpayer continues to report all transactions on their individual Form 1040. When the remaining debts are discharged at the end of the case, the CODI is reported on the debtor’s Form 1040, using the Bankruptcy Exclusion, and tax attributes are reduced on the debtor’s 1040 return.
Consider Whether Later Bankruptcy May Be Better
As we demonstrated earlier, many CODI transactions result in high tax liabilities caused by both taxable CODI and gain on the disposition of property. Before the debtor rushes into bankruptcy to avoid tax on CODI, they should also estimate the tax liability on disposition of the property. A bankruptcy does not exclude the gain on the deemed sale of foreclosed or repossessed property.
It may be better to wait and declare bankruptcy 3 years later to discharge the tax on disposition. Second mortgages are often not discharged in a foreclosure and liability often remains after a short sale. These could also be discharged if the debtor declares bankruptcy.
A later bankruptcy is generally only beneficial if the debtor is not keeping any properties. If the debtor retains property, the IRS will file a tax lien on that property as soon as they realize the large amount of the liability, and a later bankruptcy will not remove the tax lien.