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Tax Liens Complicate Bankruptcy Filings

On the other hand, a Georgia couple filed a bankruptcy petition under Chapter 13 in 1996 after having been notified by the IRS that they owed back taxes and it intended to collect them.

In the bankruptcy petition, the couple lists the IRS as a creditor with a claim of $338,571. However, the IRS filed a claim for $428,780. The couple filed an objection to the IRS claim on the grounds that they didn't owe it. For about a year, the couple and the IRS engaged in discovery proceedings on the issue, but just as the case was to go to trial, they and the IRS agreed to dismiss the objection without prejudice. Several months later, the bankruptcy case was dismissed on a motion by the IRS to which the couple did not object.

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The IRS then began collection proceedings, and the couple asked the Tax Court to intervene, arguing that they did not owe the tax. But the Tax Court held that they had had "the opportunity to dispute the underlying [tax] liabilities" in bankruptcy court. For that and various procedural reasons, the Tax Court threw out their case.

The lesson for struggling Americans is that the combination of taxes and bankruptcy is a complex and potentially dangerous situation. The IRS may occasionally screw up, but you could just as easily shoot yourself in the foot. If you're in this kind of situation, consult a good lawyer or other expert.

Mortgage interest. Most people understand that interest paid on a home purchase mortgage is deductible, up to $1 million of debt. And that's true of interest on home equity loans up to $100,000 of debt. But less well known is the fact that interest on home equity loans not used to buy, build or improve a home is not deductible under the alternative minimum tax. That's a provision that can bite AMT payers, who are becoming more numerous.

And the rules can become particularly confusing in refinancings, especially multiple ones. To help clarify things, the IRS said last week that interest in multiple refinancings remains "qualified housing interest," which means deductible for the AMT, "to the extent that the amount of the loan is not increased." That means that as long as the taxpayer doesn't borrow more than the outstanding principal balance, he or she may deduct the interest.

The IRS analysis goes like this: Ms. Smith buys a house in 1990 and borrows $100,000 to finance it. In 2000, by which time the loan balance has been paid down to $90,000, she refinances it, borrowing $90,000. Since she didn't borrow more than the outstanding balance, interest on the new loan is completely deductible. But in 2004, with the loan balance now down to $80,000 she refinances and borrows $110,000. For the AMT, she may deduct only the portion of the interest attributable to $80,000.

It's Revenue Ruling 2005-11, available on www.irs.gov.

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