Chapter 13 Bankruptcy question

[nwtaxlady]

I have a NEW client. He had filed Chapter 13 Bankruptcy. In prior years his return consists of Schedule E and a Schedule C.
One of the creditors is Home Depot and American Express, and Verizon etc. I think that "maybe" or "could have been" in prior years some of these expenses were written off on Sch E or C. Say expenses for the rental put on his Home Depot credit card, or cell phone expenses on his Sch C?

Do I need to be concerned? If so, what do I do???

Or is the Chapter 13 Bankruptcy irrelevant in this case?

Thanks in advance..... never have come across this until now.

[Wonky Numbers]

In a chapter 13 they are required to pay back the debt so in this case it doesn't affect prior returns. Just think of it as if they put it on a credit card and now they are paying it off - they still get to take the expense in the year that it was charged.

[JohnH]

Just be sure they understand there will be "phantom income" on the current and future years' returns. The repayment on that credit card debt must come from current earnings, with no offsetting expense aside from interest,. Sometimes the size of that phantom income snowball can grow very large, and your average taxpayer will not understand (or refuse to understand).

[nwtaxlady]

Phantom Income on Chapter 13 when debt is being paid back??? I am confused.

I agree with WonkyNumbers, that if it is required that the debt be paid back, then nothing is done on the returns (think of it as a loan).

JohnH, you are confusing me. Why would there be phantom income on any returns if he is paying back the debt?



On a side note, I know he is paying back the debt. He sold his Personal Residence and the Proceeds of $82,000 went to the bankruptcy.

[Burke]

I gathered he just meant it was an expense undeductible in the current year. (Is that a word?)

[JohnH]

As Burke pointed out, I use the term "phantom income" to try and help clients understand what happens with repayment of principal on loans. In the year the borrowed money is spent, they realize a nice deduction. However, the principal repayment in future years must come from either 1) earnings; or 2) additional borrowings. They see all this money going out and then can't understand why they owe so much tax in the repayment years. Cash is still going out, but there's no tax deduction.

This same issue arises when someone buys an expensive piece of equipment with long-term financing. They get the bonus depreciation in the year of purchase, but then the remaining depreciation deductions are a fraction of the principal repayments.

In the case of a client who is struggling financially, the problem becomes more acute because they are often cash-poor in the recovery years and a long period to time elapses between the original deduction and the principal repayments. Trying to explain to someone that they're still paying taxes for nondeductible principal repayments on a purchase they made 3-5 years ago gets to be unbelievable to them. When I was younger I lost clients over this issue from time-to-time, so I developed the habit of warning them and reminding them about it in advance.

[DaveinTexas]

Good advice

That is good advice Mr. John. I just had a new client come to me that said he left his previous CPA because the CPA's advice was, "You could have purchased a (insert Truck, Equipment, etc) for your business and saved $20,000 in taxes". My client didn't appreciate the advice, not because it was after the fact, but because "the $50,000 write off for the truck is nice, but that $1,500 monthly payment stays with you for a while!"

[DaveO]

I always remind business clients considering debt that it must be paid back with after tax dollars.

[JohnH]

Debt repayment isn't a huge problem if the principal repayment approximates the depreciation, which is often the case with rental property. But accelerated depreciation creates huge mismatches. Same for businesses loans used to pay current expenses but having lengthy amortization periods. In this case, credit card repayments stretching out over time due to a Chapter 13 bankruptcy probably create a similar issue.

[nwtaxlady]

can you explain this to me please JohnH

Just be sure they understand there will be "phantom income" on the current and future years' returns. The repayment on that credit card debt must come from current earnings, with no offsetting expense aside from interest,. Sometimes the size of that phantom income snowball can grow very large, and your average taxpayer will not understand (or refuse to understand).

So if they file Chapter 13 Bankruptcy where does this "phantom income" come from? I guess I need a detailed explanation here.


If he filed the other kind of Bankruptcy where they wipe off all your debt, then those expenses that were written off on prior returns, say the Verizon phone bill. Then that amount of debt from Verizon that was wipe off clean would be the "phantom income".... Right?? That is how I see it.

Since he filed Chapter 13 Bankruptcy and he has to repay all the debt in the bankruptcy then there should be no phantom income is the way I see it.

Or do I have this completely wrong?

[Maude Lebowski]

Debt repayment isn't a huge problem if the principal repayment approximates the depreciation, which is often the case with rental property.

This is why I encourage clients to use the slowest method of depreciation available, particularly if the property is financed.

[mscash]

I have a NEW client. He had filed Chapter 13 Bankruptcy. In prior years his return consists of Schedule E and a Schedule C.
One of the creditors is Home Depot and American Express, and Verizon etc. I think that "maybe" or "could have been" in prior years some of these expenses were written off on Sch E or C. Say expenses for the rental put on his Home Depot credit card, or cell phone expenses on his Sch C?

Do I need to be concerned? If so, what do I do???

Or is the Chapter 13 Bankruptcy irrelevant in this case?

Thanks in advance..... never have come across this until now.

Reading between the lines, I would say he paid for the building improvements with borrowed funds so they have been paid for. The fact that he doesn't pay back the loan is a different issue.