More than 775,000 bankruptcy cases were filed in the first half of 2018 – people and businesses alike can turn to the bankruptcy process to assist them in getting out of crushing debt. Unfortunately, even the simplest bankruptcy proceedings cost money. Attorneys' fees for bankruptcy cases range from $1,500 to $20,000 and up, depending on which chapter is filed and how complicated the case is. While attorneys' fees and filing fees for filing bankruptcy are generally not tax deductible. You may also be able to deduct some of what you pay under a Chapter 11 or Chapter 13 plan, if the items you're paying would've been deductible without the bankruptcy.
Bankruptcy legal fees are usually not tax deductible; however, if you're in a Chapter 13 bankruptcy, you can take deductions for certain items paid through the trustee, like mortgage interest, property taxes and alimony.
What Are Tax Deductions?
A tax deduction is a certain dollar amount you can deduct from your annual income when you file your taxes to reduce that income and thus reduce the amount of tax you owe. Deductions are for certain types of expenses, including home mortgage interest, business expenses, alimony and property tax payments. You can choose to itemize your deductions, which means that you add up all the deductions you have and subtract them from your income, or you can choose the standard deduction, which is $12,000 for an individual or $24,000 for a married couple filing jointly as of 2018. Individual deductions only matter if you're itemizing; if you take the standard deduction, you don't need to add anything up. However, people with certain types of expenses above a certain amount will benefit from itemizing if it takes them above the standard deduction.
What Is Bankruptcy?
Bankruptcy is a legal process by which individuals and businesses can obtain relief from debts. Bankruptcy is commenced by filing a petition in bankruptcy court, where a case is commenced. Chapter 7 bankruptcy cases are liquidation cases; if you file a personal Chapter 7, you're essentially walking away from everything. A Chapter 7 trustee is appointed in the case to review your assets and see if there's anything he can sell (although, because of something called "exemptions," most people are able to keep all their things). If the case has no assets available for the trustee, he closes it, and if you get your discharge order, you don't have to pay anything back. Chapter 13 bankruptcies are reorganizations for individuals, where you can pay things back over time.
Are Bankruptcy Legal Fees Deductible?
Bankruptcy legal fees for personal bankruptcy are not deductible expenses for tax purposes. The IRS specifically states that personal legal fees cannot be used as deductions. You also cannot deduct the court filing fee or any other court fees you may incur during your case. However, if you file a Chapter 13 bankruptcy, your payments to the trustee may be deductible in part.
How Does Chapter 13 Bankruptcy Work?
When you file Chapter 13, you do so with the goal of filing a plan of reorganization, where you'll propose a monthly payment over a period of 36 to 60 months. That payment will allow you to catch up on your mortgage, pay past due property taxes and even pay the IRS for back taxes. The payment is made to a Chapter 13 trustee, who collects the funds, takes a percentage as her fee, and distributes the rest according to the court-approved plan.
Are Chapter 13 Trustee Payments Tax Deductible?
There is no such thing as Chapter 13 tax deductions, per se. However, because your payments to the trustee are being forwarded to your mortgage lender or other creditors, you may be able to deduct a portion to the extent that you would have if you had not filed bankruptcy. The IRS allows deductions for the interest you pay on your mortgage every year, as well as property taxes paid. If you're paying back alimony through the Chapter 13 plan, that may be deductible, too. The Chapter 13 trustee keeps track of all the payments she collects and where she sends the money, and you can contact your bankruptcy attorney to get a report on what was disbursed and to whom.
Home Mortgage Interest Deductions
The IRS allows a deduction for home mortgage interest paid during the tax year. The deduction is available only for interest paid on your residence or on a second home, and only if the mortgage was used to either buy the property, build the property or improve the property. If you refinanced your mortgage to get a better interest rate, you can't deduct the interest. Similarly, if you refinance and get money from it, or if you get a home equity loan from the house, but you don't use the money for improvements or repairs, the interest is not deductible.
If part of your Chapter 13 plan payment goes toward your mortgage, the mortgage company will apply some of the money to principal and some to interest, and at the end of the year, it will send you a Form 1098 showing interest paid. You can use that form to deduct the interest on your taxes. For example, if you're behind on your mortgage and you're paying the trustee $5,000 per month through the plan, and she pays $2,000 of that amount to your mortgage company every month, and $500 of that is interest, you'll have paid $6,000 in mortgage interest that year, even though the money is going through the plan.
Property Tax Deductions
Sometimes, a Chapter 13 plan will propose to pay back property taxes. If your payments to the trustee include past due property taxes, you may be able to take a deduction for the portion that went to those taxes. Note, however, that if you have past due taxes you're paying through your bankruptcy, the claim filed by the taxing authority probably includes fees and penalties. These fees and penalties are not deductible; only the amount attributable to the tax is deductible.
Deductions for Alimony Payments
If you pay court-ordered alimony, you can use those payments as deductions on your tax returns. If the trustee is paying on a claim for past due alimony, the portion of the payment attributable to the alimony claim is deductible. Alimony does not include child support, so if you're paying back child support through the plan, you cannot deduct that portion of the payment.
Deductions for Business Bankruptcy
Businesses are allowed to deduct ordinary and necessary expenses. If a business files bankruptcy and tries to deduct legal fees for the bankruptcy filing, the business will have to show that the bankruptcy was ordinary and necessary, which is a complicated issue best saved for a CPA or a tax attorney.
A Note About the Bankruptcy Discharge and Taxable Income
Ordinarily, if you don't pay a debt in full and the creditor forgives the debt, you have to pay taxes on the forgiven portion, because it's considered income to you. A bonus of the bankruptcy discharge is that debt discharged in bankruptcy is not considered taxable income, no matter how much debt you discharged. So, although you can't deduct much in the way of legal fees, you can still get rid of a considerable financial burden without incurring the huge tax bill that would come otherwise. For example, if you owe $50,000 on a credit card and settle the debt with the creditor and pay $30,000 in full and final settlement, you'll have to pay taxes on the $20,000 difference. However, if you discharge $50,000 in bankruptcy, there is no taxable event for you.
- IRS: Publication 529 (2017), Miscellaneous Deductions
- IRS: Topic Number 452 - Alimony
- U.S. Courts: Chapter 13 - Bankruptcy Basics
- U.S. Courts: Chapter 7 - Bankruptcy Basics
- The Law Dictionary: Are the Fees I Paid My Bankruptcy Lawyer and Trustee Tax Deductible?
- Debt.org: The Cost Of Bankruptcy
- U.S. Courts: June 2018 Bankruptcy Filings Fall 2.6 Percent
- USA.gov: Tax Credits and Deductions
- IRS: Publication 936 (2017), Home Mortgage Interest Deduction
- MarketWatch: What the New Tax Law Will Do to Your Mortgage Interest Deduction
- IRS: 2017 Instructions for Schedule A (Form 1040) (2017)