Advising Financially Stressed Clients

When debts surpass their means, be ready with wise counsel.

Tax and financial advisers should be prepared to discuss a range of possibilities for their clients who are facing financial difficulties and help make the best choices given their circumstances and goals. Should they consider bankruptcy? If they want to avoid bankruptcy, how can they best reduce their debt? Which actions should clients avoid? Which actions should professionals handle? This article highlights some nonbankruptcy options for debt reduction and the related tax consequences and identifies actions to avoid that could cause legal difficulties if the client ultimately files bankruptcy.



A client can take certain actions to try to settle debts without filing bankruptcy.


Debt negotiations. Any debt, whether evidenced by a formal loan agreement or not, can be negotiated. A client may be able to negotiate a settlement with a creditor (for example, a hospital) for less than the balance due. However, if the agreed-upon balance is not paid, the account may be turned over to a collection agency.


Clients who want to negotiate a settlement with a credit card company should be cautious. If clients use a debt management agency, they should first check with the Better Business Bureau, the National Consumer Law Center or the Consumer Federation of America to ensure the agency’s reliability. Reputable agencies and attorneys who handle credit card negotiations charge a fee for negotiating a certain number of cards, plus a deposit of up to 50% of the unpaid balance on the cards. Once a settlement is reached, the deposit is used to pay the negotiated debt balance. If the credit cards are settled successfully but the client has others that are unpaid, the client should wait at least 90 days before filing bankruptcy on the remaining debts to avoid preference challenges (discussed later in this article).


For debts that are evidenced by a formal loan document, negotiation strategies include extension and modification agreements. Extensions involve a change in the payment schedule itself. One common practice involves extending the term of the loan by tacking past-due payments on to the end of the loan. For example, if three $500 monthly payments are not made on a 15-month loan, the three $500 payments would be moved to the end of the loan, extending the term of the loan to 18 months. Interest would typically continue to accrue daily, increasing the total amount paid over the life of the loan. In contrast, loan modifications change the terms of the agreement, such as principal amount, interest rate or length of the loan, resulting in a lower payment amount. The lender might in return require a “balloon” payment at the end of the original term.


In conjunction with an extension or modification agreement, the lender might try to improve its position by requiring the client to provide new or additional collateral and/or a personal guarantee of the debt.


Surprisingly, there might be times when a lender offers to release collateral when a loan is in trouble. This could occur when the client is contemplating filing a Chapter 13 repayment plan bankruptcy and the value of the primary residence is less than the mortgage. In a Chapter 13 case, mortgages on the primary residence generally cannot be modified in bankruptcy without the lender’s consent, unless the loan is cross-secured with other real property or personal property (for example, a car). If the mortgage is secured by the primary residence and other property, the mortgage could be reduced to the value of the primary residence (called a “cram down”). The lender might offer to release the additional collateral to avoid this involuntary loan reduction.


For example, assume the client’s home has a fair market value of $100,000, the client’s car has a fair market value of $5,000, the current mortgage balance is $150,000, and both the home and the car are collateral for the mortgage. In a Chapter 13 proceeding, the bankruptcy court could reduce the mortgage to the home value of $100,000. If the car was released as collateral prior to the bankruptcy proceeding, the mortgage balance of $150,000 could not be modified without the lender’s consent. If the lender offers to release collateral, clients should consult with bankruptcy counsel to avoid giving up valuable rights in a Chapter 13 bankruptcy.


Tax consequences. Successful debt negotiations can have tax consequences. Generally, full or partial forgiveness of debt is taxable cancellation of debt (COD) income under IRC § 61(a)(12). Even if principal is not reduced, significant modifications in the terms of a loan can trigger an exchange that results in COD income (Treas. Reg. § 1.1001-3(b)). The modified debt is treated as new debt. Under IRC § 108(e)(10), the taxpayer recognizes COD income equal to the excess of the issue price of the new debt over the amount of the original debt. Release of collateral generally is considered a significant modification for nonrecourse debt; for recourse debt, release of collateral is significant only if it results in a change in payment expectations (Treas. Reg. § 1.1001-3(e)(4)(iv)).


IRC § 108(a) provides for specific exceptions to income recognition from debt forgiveness. For example, a taxpayer who is insolvent immediately prior to the debt forgiveness may exclude COD income up to the amount of the insolvency. However, section 108(b) requires a reduction in the taxpayer’s tax attributes for the amount of excluded income. Homeowners are entitled to exclude income from the release of acquisition indebtedness on a qualified principal residence occurring before Jan. 1, 2013. Per section 108(h)(1), the basis of the residence must be reduced by any amount of the discharged debt that is excluded from gross income.



If the client is in default on his or her mortgage, the lender could file a foreclosure suit with the court. The court enters a judgment of foreclosure and sets a sale date. The property is usually sold at public auction, and the lender has the right to bid in the amount of its mortgage. After the judgment of foreclosure is entered, the client has a right to redeem the property by paying the full amount owed. The redemption period varies by state and can range from one to 12 months after the judgment of foreclosure is entered. The high bidder receives a certificate of sale, which entitles him or her to the property if it is not redeemed. The lender can sue the client for any deficiency balance.


A lender may suggest a “deed in lieu of foreclosure” instead of going through the more time-consuming judicial foreclosure, which could last six months or more. The lender receives title to the property in exchange for canceling the debt. The debtor loses any right to redeem, or reacquire, the property. While simpler and cheaper for the lender, a deed in lieu of foreclosure requires the client to move out of the home sooner. This option might be advisable if the property is worth much less than the mortgage balance. However, the client should seek the advice of legal counsel before agreeing to a deed in lieu of foreclosure.


The client can challenge the foreclosure procedure in court. Certain technical foreclosure defenses could delay the foreclosure. Although ultimately the client would lose the house, these defenses might enable the client to remain in the house without making mortgage payments for 12 months or more. The client should consult with an attorney experienced in foreclosure defense.


For tax purposes, foreclosure is treated as a sale where the amount realized includes the debt canceled (Treas. Reg. § 1.1001-2(a)). No COD income will be recognized when property is secured by nonrecourse debt. The full amount of the debt canceled is included in the amount realized on the sale of the property without regard to the property’s fair market value. When property is secured by recourse debt, the foreclosure is treated as two separate transactions. The amount realized on the deemed sale of the property equals the property’s fair market value. The COD income equals the amount of debt canceled in excess of the property’s fair market value.



Many financially distressed clients try to resolve their debts in hopes of avoiding bankruptcy, but financial advisers should warn them about a number of risky pre-bankruptcy actions.


The collection process. The client should understand that certain actions might facilitate the creditor’s collection efforts prior to filing bankruptcy.


  • Contacting creditors. Clients should not contact creditors who have not contacted them. Don’t wake the sleeping baby!
  • Threatening bankruptcy. Clients should not tell a creditor they are considering bankruptcy unless they have hired a bankruptcy attorney. The creditor might rush to obtain a judgment against the client before bankruptcy prohibits further collection.
  • Maintaining bank balances. Clients risk losing money in their bank accounts. Creditors can seize it or ask the bank to freeze the account. Banks can offset money in the account against a debt owed to the bank without court approval. Clients should promptly pay their normal monthly bills and avoid carrying large balances. They might consider keeping money in the form of cash or money orders.
  • Ignoring lawsuits. Once a creditor files a lawsuit, clients must appear in court and object to the debt. If they fail to do so, the creditor can obtain a default judgment and promptly start wage garnishments or freeze bank accounts and/or put liens on the client’s property.


Potentially fraudulent transactions. Debts might become nondischargeable and/or property could be recovered by the court in a bankruptcy or state court proceeding if the client engages in any of these activities:


  • Transferring property with the actual intent to keep it out of creditor’s hands. The client also could be subject to criminal prosecution for committing intentional fraud.
  • Disposing of assets at less than fair market value within four years of bankruptcy. Even if the client does not intend to hide assets from creditors, such a transfer can be treated as “constructive fraud.” For example, selling property at a price less than what would be received in an arm’s-length transaction or paying a family member’s bills fit under the constructive fraud umbrella.
  • Increasing debt through borrowing, balance transfers on credit cards or loan consolidations. Creditors argue that engaging in these transactions too close to filing bankruptcy, knowing repayment is unlikely, is a fraud on the creditor extending the new credit.
  • Making contributions to a 401(k) in excess of the normal amount deducted from each paycheck. Although a certain amount of pre-bankruptcy planning is allowed, trying to convert assets into “exempt” assets is risky and could be interpreted as intent to defraud creditors.


Exempt property. Exempt property cannot be attached or levied upon by creditors. Exempt property includes Social Security, disability, unemployment, workers’ compensation and pension benefits. A client should preserve exempt property by avoiding the following actions:


  • Paying unsecured debts with exempt property. The client should not waste exempt property by paying unsecured debts (such as credit cards and medical bills) that normally would be discharged in bankruptcy.
  • Moving out of the home. Moving out of the residence could result in loss of the homestead exemption, which protects part of the owner’s equity.
  • “Borrowing” from qualified retirement accounts. Pensions, IRAs, 401(k)s and other qualified retirement plans are exempt and should not be used to pay creditors. There also can be negative tax consequences. IRC § 72(t) requires early distributions from a qualified retirement plan to be included in gross income and subjects them to an additional tax equal to 10% of the amount of the distribution. As detailed in section 72(p), certain actions could cause loans from a plan to be treated as distributions. For example, the outstanding balance of a loan will be treated as a distribution if the taxpayer defaults. Also, loan amounts that exceed certain thresholds and loans with a repayment period greater than five years are treated as distributions. The five-year rule will not apply when the loan proceeds are used to purchase a principal residence.


“Preference” payments. Preference payments are made to select unsecured creditors prior to bankruptcy, enabling them to receive more than other unsecured creditors would receive. The bankruptcy court can recover these payments from the debtor or the recipient. Preference payments are not fraudulent and would not result in nondischargeable debt. Two primary examples of preference payments are payments to relatives or friends within one year prior to filing bankruptcy and payment to an unsecured creditor of more than $600 within 90 days prior to filing bankruptcy, unless the payment is in the normal course of business.


Divorce issues. Support payments and property settlements present extremely complex issues. If a client is considering both divorce and bankruptcy, advice of competent counsel in each of these areas is essential.



A bankruptcy negatively affects a client’s credit rating and will usually make it more difficult to obtain credit in the future. Therefore, it should be considered as a last resort, not as the first solution to resolving credit problems. Competent bankruptcy counsel should be consulted if a client is seriously considering filing bankruptcy.



CPA tax and financial advisers play a vital role in counseling the financially distressed client. Advice can focus on what affirmative actions are available to the client and the tax consequences of various options. Of equal importance, however, is recognizing what actions could have severe consequences if the client ultimately files bankruptcy. If it appears to the financial adviser that a bankruptcy is likely, always advise the client to consult legal counsel.





  CPA advisers can help clients in financial straits avoid bankruptcy or avoid missteps that could further cloud already bleak finances.


  Debt settlement negotiations with credit card companies should be done with caution. Any debt management agency engaged should have a good record for reliability. If a home mortgage lender offers to release other property held as collateral, clients should consult an attorney to avoid giving up valuable rights in a subsequent Chapter 13 bankruptcy.


  Various types of debt modifications can result in taxable income to the debtor from cancellation of debt. Some types of debt forgiveness are excluded from income, but they are not without potential costs to the taxpayer. The insolvency exclusion, for example, requires a corresponding reduction of tax attributes, and one for qualified principal residence indebtedness reduces the home’s basis.


  A “deed in lieu of foreclosure” that gives title to the mortgage holder in exchange for canceling the debt may be preferable to foreclosure if the amount owed far exceeds the property’s value.


  Debtors facing a collection action sometimes inadvertently facilitate the creditor’s collection efforts. They can take some actions to preserve property as exempt from a bankruptcy estate. On the other hand, such actions as disposing of or transferring property could run the risk of recovery by a court and could result in corresponding debts becoming nondischargeable.


Gail P. Petravick ( is an attorney with bankruptcy specialist law firm Ostling & Associates Ltd. of Bloomington, Ill., and an adjunct instructor at Bradley University. Coleen Troutman ( and Mollie T. Adams ( are an associate professor and assistant professor, respectively, at Bradley University.


To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at or 919-402-4434.





JofA article

Taxes in Troubled Times,” April 2009, page 36


Use to find past articles. In the search box, click “Open Advanced Search” and then search by title.



Advising Clients in Tough Times (#029885PDF, on-demand)


CPE self-study


For more information or to make a purchase, go to or call the Institute at 888-777-7077.


The Tax Adviser and Tax Section

The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at The current issue of The Tax Adviser is available at


PFP Member Section and PFS credential

Membership in the Personal Financial Planning (PFP) Section provides access to specialized resources in the area of personal financial planning, including complimentary access to Forefield Advisor. Visit the PFP Center at Members with a specialization in personal financial planning may be interested in applying for the Personal Financial Specialist (PFS) credential. Information about the PFS credential is available at






Where to find November’s flipbook issue

The Journal of Accountancy is now completely digital. 





Get Clients Ready for Tax Season

This comprehensive report looks at the changes to the child tax credit, earned income tax credit, and child and dependent care credit caused by the expiration of provisions in the American Rescue Plan Act; the ability e-file more returns in the Form 1040 series; automobile mileage deductions; the alternative minimum tax; gift tax exemptions; strategies for accelerating or postponing income and deductions; and retirement and estate planning.