Should I file Bankruptcy as a Result of my Short Sale or Foreclosure?

I often hear that folks who are going through a short sale are told that they should file bankruptcy.  While it is true that any debt that is cancell...


I often hear that folks who are going through a short sale are told that they should file bankruptcy.  While it is true that any debt that is cancelled in a title 11 bankruptcy is not taxable (subject to attribute reduction), I don’t think that bankruptcy should be your first choice.  Bankruptcy alone can cost several thousands of dollars to file and take many months to close.  Plus there are certainly negative credit effects.

If that property is your principle residence then you may be covered under the Mortgage Forgiveness Debt Relief Act.  But if you took cash out then you may have a serious taxable event that could be reduced if you filed bankruptcy.  The key is to make sure that the debt is included in the bankruptcy estate and cancelled as part of the bankruptcy.  If you look on a 1099-C you will see a bankruptcy box.  If this box is checked then you can exclude the cancelled debt from income by using form 982.

The problem is that often the home and the mortgage get released from the bankruptcy because there is no equity and, therefore, no benefit to the creditors.  In addition, just because you are bankrupt does not mean that you are insolvent in the eyes of the IRS.  Depending on your situation, retirement funds are often exempt assets and are therefore not available to creditors.  However, the IRS will require you to use them in an insolvency calculation.  So be careful.

Bankruptcy attorneys are great, but I sometimes have to be cautious in referring someone to talk to one.  Why?  Because if my client goes to see one they often come back with a bankruptcy, which may or may not be the best option for them.  Talk to a few attorneys and try to determine if you should file for bankruptcy as a result of a short sale or foreclosure.  This may not be what you need at the end of the day.

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