A three-point test to discharge taxes in Chapter 7 bankruptcy

In order for tax debt to be dischargeable, the taxes must meet a three-point test:

• First, the tax must be for a year for which the return was due plus any applicable extensions at least three years before the bankruptcy filing.
• Second, a tax return for the particular tax year sought to be discharged must have been filed at least twoyears before the bankruptcy filing.
• Third, the taxes must have been assessed at least 240days prior to bankruptcy filing.

There have been several Bankruptcy Court and Circuit Courts of Appeals decisions over the last few years that have dealt with the second point mentioned above: namely, when the return is filed. These cases have dealt with the question of the effect of the Internal Revenue Service filing a substitute for return (“SFR”) for a taxpayer who has not filed returns.

An SFR essentially is the way that the Internal Revenue Service can file a return for a taxpayer and assess tax when it does not have an actual return. A number of the court decisions that have considered the issue have held that an SFR does not satisfy the tax return filing requirement that is set out in the second point set out above. In other words, an SFR that has been processed and assessed is not a tax return for purposes of a bankruptcy discharge. The taxpayer’s subsequently filed return will not qualify as a filed return under the two year rule in bankruptcy.

Enter a Supreme Court verdict

Thus far, the Internal Revenue Service had not pushed this issue in a broad sense; however, the tide has now turned. The Internal Revenue Service has now issued a policy statement indicating that it will not consider a tax return after an SFR has been filed as atax return for the purpose of bankruptcy discharge. This applies to most taxpayers. For all practical purposes, this is now the law and only a decision by the United States Supreme Court will change it.

For people who are delinquent in filing tax returns who have insurmountable tax debt, there had been hope. If the taxpayer files the return and waits two years, the taxes will be dischargeable. Now, if the Internal Revenue Service beats the taxpayer to the punch by filing an SFR, the taxes will not be dischargeable in bankruptcy.Unfortunately, it can reasonably expect that the Internal Revenue Service will be filing more SFRs and will file them quicker. This means that more and more taxpayers will not have bankruptcy relief as an option.

Chapter 13 bankruptcy is a wholly different matter, one that is best covered in a bankruptcy counseling session.

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However, many Chapter 7 debtors are in default on their mortgage obligations at the time of the bankruptcy filing.  Some of these people wish to surrender (give up) the property as part of the bankruptcy, and discharge the debt.

Short sales and foreclosures: a good idea for your situation?

We often counsel clients on how a short sale, foreclosure or mortgage modification factors into their bankruptcy case. In both of these situations, we attempt to prevent clients from taking action that wipes out the “fresh start” that bankruptcy offers.

Short sales. Some clients have a mistaken belief that having a foreclosure will in some way damage their ability to obtain credit in the future, even though they are already in bankruptcy.  As a result, they spend a great deal of time and energy in attempting to arrange a short sale.  Unfortunately, this can lead to substantial expense, and, in some cases, a large amount of post-petition debt that may not be discharged in the bankruptcy case.  Unless there is an extremely good reason for attempting a post-petition short sale, you are strongly advised to walk away from the property and avoid getting involved in any short sale attempt.

As to the expense, it is necessary for the debtor to obtain in the bankruptcy case an order for an abandonment of the property in order to do a short sale, if the bankruptcy case has not been closed.  This is an expensive procedure that requires notice to all creditors and a court hearing.  This cost is not included in the fee that you paid to file the bankruptcy case.  Therefore, should you wish to obtain an order of abandonment, you will be charged for expenses that we incur and services that we render, the latter at our firm’s hourly rates for attorneys and paralegals.  You will also be required to deposit with us an advance fee to cover these costs, which will likely approach the amount that you paid to file the bankruptcy case.

Foreclosures. The second involves clients who wish to in some way assist their lender that is attempting to foreclose, perhaps to speed the process up for the lender, help the lender save expenses, or in some other way “do the right thing” to help the lender.

From the lender’s point of view, foreclosure is neither difficult nor lengthy.  On average, it takes about 75 days to complete a foreclosure.  However, if you ask for our advice or assistance in trying to speed up the process for your lender, then please realize that such work is not included in your bankruptcy fee.  You should expect to be charged our firm’s hourly rates for attorneys and paralegals, and to be required to deposit with us an advance fee to cover our work, which will likely approach the amount that you paid to file the bankruptcy case. This makes no sense for you.  You have a fresh start and should simply let the foreclosure process run its course.

This post is an attempt to explain a very complex legal matter. It is not legal advice. If you find yourself in financial hardship, only a consultation with a qualified bankruptcy attorney is reliable advice. The advice you get may be priceless to your financial future and emotional well being.

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Surrender. You can surrender (turn in) the property to the lender and discharge the debt.  This often makes good sense where a car is underwater (worth less than what’s owed) or is unaffordable.

Reaffirmation. “Reaffirmation” means that a debtor in a bankruptcy case waives the discharge of a specific debt.  Reaffirmation allows a debtor to retain property that is financed and subject to a mortgage lien and continue making payments.  Reaffirmation is required for personal property (anything other than land or buildings) that the debtor wishes to retain and pay for in installments.  In particular, note that if your vehicle is financed, and you do not reaffirm the debt or redeem the vehicle after filing a Chapter 7 bankruptcy case, then the creditor is free to repossess the vehicle.

Reaffirmation is not required for real property (land or buildings). A debtor can retain real property so long as the debtor continues the required payments.  However, some creditors secured by real property will refuse to send statements or advise of increases in interest, insurance escrow payments, and tax escrow payments; further, absent a reaffirmation agreement, some mortgage companies may stop reporting to the credit bureaus timely payments.  This is why you must  keep proof of cancelled checks, debits from bank accounts, etc. to show that timely payments were received by the mortgage company.  As a general rule, Mitchell & Culp, PLLC discourages reaffirmation unless the property has a good deal of equity (value in excess of what is owed).  Among the reasons for this:

• many debtors reaffirm believing that they can make the payments, only to later learn that they cannot.  A foreclosure, repossession or other collection activity after reaffirmation may mean that the debtor who has been discharged from his or her debts will end with a large deficiency debt.  Thus, the reason for filing – discharge of debt – has only partially been successful.  This is particularly troublesome in the reaffirmation of automobile debt.
• some creditors will promise to “remove the bankruptcy” or default notation from your credit report upon reaffirmation.  This promise may be meaningless.  First, a Chapter 7 bankruptcy will appear on your credit report for a period of ten years.  Second, the promise may not be true.  If this promise is important to you, then please consider obtaining a written promise from the creditor to remove the notation, and obtaining this written promise prior entering into a reaffirmation agreement.  Mitchell & Culp, PLLC urges you to carefully consider reaffirmation.  In the case of an automobile, do everything possible to arrange for alternate transportation.  Remember that financing for the purchase of an automobile is generally available upon entry of a discharge order; if you desire to obtain financing while your Chapter 7 case is open, there are lenders who offer such financing.  As to homes, many mortgage companies will continue to send monthly statements after the bankruptcy filing.  If you reaffirm a debt, the lien will remain on the financed property, as if you’d never filed.

Redemption. An alternative to reaffirming the debt secured by personal property is to redeem the property.  Redemption allows you to buy the personal property outright, for one lump sum, at its current value.  This may make sense for you if

• you can come up with the cash needed to buy the property at its fair market value at the time of the bankruptcy filing and
• the amount owed on the loan is more than the current value of the property securing the loan.

Pay off the debt.  Finally, if you have the ability to come up with the cash needed to pay off the entire debt as of the date of the bankruptcy filing, and the amount owed is less than the current value of the property, you may wish to pay off the debt.

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We obtain some basic information from you over the telephone, and, if appropriate, schedule an initial consultation with you, in our office.  There is no charge for the consultation unless and until you hire us.

During the consultation, we’ll discuss what you own, what mortgages or liens are on the property that you own, what debts you have, your income, and other facts relating to your finances.

The Chapter 7 process

If we determine that a Chapter 7 bankruptcy is your best option for dealing with your debt, and that you wish to hire us to file your bankruptcy petition, then you can expect the following process.

1. Upon your completion of our office’s paperwork regarding your finances, and a mandatory online credit counseling course, you’ll spend at least a few hours in our office, working with us to prepare your petition.
2. Once our office files your petition, your creditors are forbidden from contacting you about the debts in your bankruptcy — creditors must communicate with us, through an orderly court process.
3. Approximately three weeks after your petition is filed, you must attend a hearing known as the first meeting of creditors; the hearing is not in a courtroom, and there is neither a judge nor a jury.  Everyone who filed for protection under Chapter 7 in Charlotte during the week that you filed must attend the same hearing.  The bankruptcy trustee assigned to your case will ask you questions about your petition; creditors have the right to attend and ask questions, but rarely do.  We attend this hearing with you.
4. You must also complete a second online course on financial management.  In the majority of Chapter 7 cases, debtors obtain a discharge — a written order from the bankruptcy court, wiping out the debts — approximately 90 days from the date on which the petition was filed.
5. When the discharge order is entered, a permanent injunction is in place, prohibiting creditors from attempting to collect the discharged debts.  This injunction lasts through your lifetime.

We’ve written elsewhere on this,  including the costs involved in filing for bankruptcy.

Call our firm or a qualified bankruptcy advisor. Together, we will determine the best strategy for legally handling your financial troubles.

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Chapter 7 is a liquidating bankruptcy.  It is normally utilized to obtain a “fresh start” for an individual debtor, and, far less often, to wind down the affairs of a business debtor.

Chapter 7 for individuals

In many cases, a Chapter 7 bankruptcy allows an individual debtor to wipe away all of his or her debts without losing any assets.  We can advise you as to whether you, as an individual, would qualify for a Chapter 7 bankruptcy; and if so, what debts of yours would go away in a Chapter 7 bankruptcy; and whether you would have to give up any property as part of the bankruptcy.

Chapter 7 for businesses

We can also help a troubled business determine whether a Chapter 7 bankruptcy would be appropriate for the business. We usually find that small businesses — those owned by an individual or partners — must be evaluated for bankruptcy protection along with their owners. Why? Owners so often personally guarantee loans for their companies —   by taking out second mortgages or pledging collateral — that what the courts view as “business” debt versus “personal” debt differs from the owners’ understanding. Often it is the business owner that needs bankruptcy protection.

The best place to start evaluating bankruptcy is in what’s called a “bankruptcy counseling” session. Many attorneys will see potential clients free of charge for such an evaluation, and only bill for that time if hired.

“This information is general and thus incomplete, and the reader should seek legal counsel for specific legal problems or questions.”

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The general news press has gotten sloppy in the language it uses for distressed real estate, so let’s start there:

• Forced sale is not used often, but when it is it would include a sheriff’s sale or a foreclosure sale.
• Foreclosure is the process by which the lender repossesses real property upon the borrower’s default.
• Short sale, though, is a consensual deal between the lender and the borrower in which the lender agrees to take less than what’s owed; a short sale is not a forced sale in the strictly legal sense of the word.

The foreclosure process, step by step

The foreclosure process is straightforward. It begins when the lender files a lawsuit in the state court in the county in which the property is located, giving notice to anyone legally responsible for the debt — borrowers, co-signers, guarantors — and upon at least ten days’ notice to the responsible parties, a hearing is held at the courthouse.

A deputy clerk, an assistant clerk, or the clerk of court presides over the hearing; the lender must show only four elements: (1) that there is a valid debt secured by the property, (2) that the borrower is in default on that debt, (3) that there is a power of sale in the agreements between the borrower and the lender, and (4) that the responsible parties had ten days’ notice or more prior to the hearing. This can all be shown by affidavit and usually is — in other words, there is no live testimony. As part of the power of sale clause, the lender hires a “trustee” or “substitute trustee” — a neutral party — to foreclose on the property. The trustee/substitute trustee attends this hearing and provides the proof of these four elements. The clerk has no authority to consider anything other than these four elements; if they are met, then the clerk shall enter an order of sale, allowing the property to be auctioned on the courthouse steps. It is generally pointless for borrowers to attend these hearings and try to delay the process.

If a borrower believes he has equitable grounds to stay the foreclosure, then he has the right to file a lawsuit in the county’s superior court, asking that a temporary restraining order, preliminary injunction, and/or permanent injunction be issued to stop the foreclosure. These lawsuits are expensive and generally a long shot. In the absence of either a successful superior court suit or a workout between the borrower and the bank, the property will be auctioned on the courthouse steps about 25-30 days after the hearing. The bank usually places a credit bid at the sale — buying the property back for something short of the full amount of the debt. Anyone can bid, but live bidders are relatively rare.

There is a ten-day “upset bid” period following the sale, in which anyone can file a bid on the property that exceeds the sale price by the greater of 5% or $750.00. The filing of any upset bid triggers a new ten-day upset bid period, until the period passes with no new filed bids. Once the ten-day upset bid period expires, the sale is final; the trustee/substitute trustee signs a “trustee’s deed” giving the property to the winner of the sale, and files documents related to the sale.

The relationship between foreclosure and bankruptcy protection

A bankruptcy filing by a borrower stops a foreclosure proceeding until such time as the lender obtains from the bankruptcy court an order giving it relief from the automatic stay of all creditor activity.

Generally speaking, a Chapter 13 debtor can propose a plan that provides for payment in full of pre-bankruptcy mortgage arrearage, and at the same time keep current on post-bankruptcy payments, and keep the house. Falling behind on either aspect will likely lead to the lender getting relief from stay and then having the right to re-start the foreclosure process.

Also speaking generally, a Chapter 7 debtor can’t do anything to stop the mortgage company from getting relief from stay and thus restarting the foreclosure process, unless the debtor is able to do what he couldn’t do prior to the institution of the foreclosure — do a mortgage modification with the lender; refinance; or otherwise come up with a large lump sum to get current on the mortgage and then keep current with the monthly payments.

I just can’t have my credit ruined by a bankruptcy!

People often tell me that “I just can’t have my credit ruined by a bankruptcy!” and these people have a pending foreclosure, are in default on several credit card obligations, and are past due on other debts. While a foreclosure is probably less prejudicial to your creditworthiness than a bankruptcy, the reality is neither is good and a bankruptcy may be the only way to get a fresh start.

Another consideration in favor of bankruptcy: foreclosures are governed by state law and the practice and procedure varies wildly from state to state while bankruptcy is federally regulated. If you own real property in more than one state, consult with a bankruptcy attorney to see if the bankruptcy process may produce a less expensive outcome. Remember this summer’s talk about GM and Chrysler entering an “orderly bankruptcy?” Bankruptcy is indeed an orderly process.

In Part 2 of 3: Questions and Answers on preventing foreclosure, negotiating with a mortgage company, and what to do about an adjustable rate mortgage that will soon reset.

In Part 3 of 3: Questions and Answers on short sales and sifting through the confusing offers from those who want to help distressed homeowners.

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Charlotte’s 210 Trade files Chapter 7 Bankruptcy

In case you missed my 2-second TV debut last week on WSOC, here’s a link to what I said about the 210 Trade condominium bankruptcy filing when the reporter asked if buyers were likely to be refunded their earnest money.

Lenders Pulling Plugs

I’ve commented twice on lenders foreclosing on commercial loans at the first sign of difficulty instead of taking a wait-and-see approach.

Last week the story in question surrounded condo developer Ray “Rip” Farris III, who sued his lender, First Horizon Home Loans, and parent company, First Tennessee Bank National Association.  Mr Farris claimed that the companies acted in bad faith when they stopped paying on a $24.4 million loan.

My quote, “You’re free to sign away your life, and you’re free to reap the benefits,” made it into the paper, but it seems a bit obscure.

The quote referred to lending agreements that contain all sorts of terms that give lenders an open door to call loans and push harsh terms on borrowers. Either-do-this-or-we-call-your-loan type terms. Of course, the guarantees make the individuals liable. We are seeing some nutty stuff from banks that have decided to get out of land loans and don’t care who they run over to do it.

I think the reporter cleaned up my original statement, which was  probably more like,

“We have freedom of contract. That means that we have freedom to make a great deal for ourselves, and we have freedom to make damn fools of ourselves.”

More on the story: Sometimes, depending on the facts of the case, I advise clients not to sue their lenders because such cases are difficult to win in NC, where banks hold great sway with the legislature. NC laws favor financial institutions, which means pursuing a case against one can cost millions and result in nothing more than wasted money. I had a builder, who is going through foreclosures and trying his best to salvage what he can with work outs, tell me recently that when this is over he would have a large number of new friends but that none of them would be bankers.

Cornelius Foreclosure

In case you missed this story, a huge project, Augustalee, in Cornelius, NC, was foreclosed by its lenders because it hadn’t met key project milestones. NOT because the developers had missed payments.

Foreclosing when the Loans are Current

Since I originally wrote about the story, The Observer has reported updates on the story, including the most recent news that the original developer has been replaced after a foreclosure auction. The mezzanine lender said the foreclosure resulted from “the borrowers’ failure to satisfy certain milestones and inability to raise additional capital needed to complete the project, including the financing of certain infrastructure and required offsite improvements.”

The developer countered in a lawsuit that the mezzanine lender promised to lend $23.5 million but paid only $19.5 million. Shortly after the fund failed to pay the remaining $4 million, the developers’ senior lender started to foreclose.

If you have business loans, I recommend reviewing them with a qualified attorney. Your legal counsel will identify possible triggers in the agreements that lenders could use to call your loans or foreclose. Lenders have legal departments to guide them in protecting their interests. You need a lawyer to help you protect yours.

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