Preventing World War III: What Happens If Your Ex Gets a Tax Bill After You File for Bankruptcy?

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Bankruptcy expert Leon Bayer answers real-life questions.

Hi Leon,

My domestic partner and I used to own a house together — we were both on the first mortgage and second mortgage home equity loan. We split up, and she transferred her share of the house to me in a settlement agreement. She remained on the mortgages because the lender would not take her name off and I couldn’t refinance in my name only because the home had no equity.

Eventually, I filed personal bankruptcy and lost the home in foreclosure to the first mortgage holder. The second mortgage holder forgave the debt on the second mortgage and then issued an IRS 1099 to my ex-partner. The second mortgage holder would not issue a 1099 to me because it said I am protected by the bankruptcy.

My ex is now trying to get me to pay her income taxes. She has contacted a lawyer who is trying to get the loan file from the lender.

Can you think of some way to unwind all this craziness before it erupts into World War III with litigation and big lawyer fees? 

Many thanks and have a good evening.

Best,

Diane

Dear Diane,

Most likely, you have no legal obligation to repay your ex for any income taxes she might owe. If that’s the case, she may be in violation of the bankruptcy’s discharge order if she comes after you. A simple reminder of that (from a lawyer) will hopefully stem World Word III.

And your ex might not even owe income tax on the forgiven mortgage debt. If that’s the case, there would be no reason for her to even start World War III.

No Tax on Forgiven Debt If Your Ex Was Insolvent

As you and your ex are aware, the IRS treats forgiven mortgage debt as income. That’s why the mortgage lender issued the IRS 1099 to your ex.

However, if your ex was financially insolvent in the year that the debt was forgiven, she won’t have to pay any income tax on that debt. If she can establish that (she should consult with a CPA), she may be able to amend her tax return so that she doesn’t owe the extra tax. (I hope it is not too late for her to amend her return, assuming she was insolvent.)

What does it mean to be insolvent? To determine if she was insolvent at the time, she would add up the value of her assets and compare that number to the amount of her outstanding debts, including the old second mortgage. If her debts were greater than her assets, then she was insolvent. Here is the link to the IRS Publication explaining all of that in simple language. I suspect she had no significant assets? If so, she should be “home free.” (Nice pun?)

Another Way to Avoid Tax on Forgiven Mortgage Debt?

Depending on what you and your ex used the second mortgage for, she also might be off the hook for the tax.  Congress created an exception to the mortgage forgiveness tax if you used the mortgage money to purchase or improve your home. If that’s the case, you don’t have to pay tax on the forgiven debt.  (Learn more about the Mortgage Forgiveness Debt Relief Act.)

But here’s the catch:  That exception ended on December 31, 2013. If your second mortgage lender forgave the debt 2013 or before, and you used the money to improve your home, your ex is probably off the hook.

If the debt was forgiven in 2014, it’s still possible (some say likely) that Congress will extend the mortgage forgiveness tax exception through 2017, and make the extension retroactive.

You Are Not Liable for Taxes on the Forgiven Debt

It was legally correct for the lender to issue the 1099 to your ex instead of to you. That is because your bankruptcy got rid of your personal liability for the debt on the second mortgage, so there was no debt to forgive. It is actually refreshing that hear that the lender is following the law (for a change).

Do You Have to Reimburse Your Ex for Any Extra Taxes She Has to Pay?

But even though you don’t owe taxes to the IRS, must you reimburse your ex for any taxes she has to pay to the IRS? It’s likely your domestic settlement agreement says yes, but, as we discuss below, your obligation to her was probably discharged in your bankruptcy.

Your domestic settlement agreement. A domestic settlement agreement will usually operate just like a marital settlement agreement. It divides up all of your joint assets, and assigns responsibility between each of you for payment of joint debts. Because you kept the house, the agreement probably required you to pay the mortgages and hold your ex harmless from the mortgages and any other debts assigned to you.

But any obligation to reimburse your ex was probably discharge in the bankruptcy. Here’s why.

If You Listed Your Ex in Your Bankruptcy

You should have listed your ex as a creditor in your bankruptcy because she was the co-obligor on your mortgage debts. If listed, your liability to her may have been discharged in the bankruptcy (assuming the debt was dischargeable, see below).

If You Didn’t List Your Ex in Your Bankruptcy

Even if you didn’t list your ex in your bankruptcy, you’re probably still OK. The bankruptcy law says that unlisted debts are also discharged provided a few conditions are met:

  • the unlisted debt was the type of debt that would be normally be dischargeable, and
  • the bankruptcy was a “no asset bankruptcy case.”

Dischargeable debts in Chapter 7 are generally anything except most kind of taxes, student loans, family support, and debts arising from intentional misconduct.

A no asset case means the court never set a deadline for creditors to file claims because there was no money to be distributed. Most Chapter 7 bankruptcies are “no asset” cases, and it is a fair assumption that yours was, too.

Was the Debt Arising From Your Domestic Settlement Agreement Dischargeable? 

Normally, obligations arising from a divorce or separation agreement are not dischargeable in bankruptcy. (See the list of debts that are not wiped out in Chapter 7.) But, this is only if the agreement was made with a spouse, a former spouse, or child.

But since you called your ex your “partner” I assume you were not married. If so, that is a good thing for you in this case. You can discharge your obligations under the domestic settlement agreement because you did not make the agreement with a spouse or former spouse.

In summary, any obligation to hold your ex harmless from the mortgage debts was dischargeable in your bankruptcy provided that:

  • she was not your spouse, and
  • the claim was listed in your bankruptcy, or if not listed, your bankruptcy was a “no asset” case.

Preventing World War III

If your ex lawyers up and comes after you to pay her tax debt, she may be held in contempt of the bankruptcy court’s discharge order. A creditor cannot pursue collection of a debt that has been discharged in bankruptcy.

A well written “lawyer letter” defending your position should be enough to make the other side back down. See if your former bankruptcy lawyer can help you with that, or find one right away who can do that for you.

–Leon

Leon Bayer is a Los Angeles bankruptcy attorney.  He is a partner at Bayer, Wishman & Leotta, a California law firm specializing in bankruptcy.  The opinions and advice in this blog post are from Mr. Bayer alone, and should not be attributed to Nolo.  By answering a question on this blog, Mr. Bayer does not become your lawyer.

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