Bankruptcy Discharges Are Not Taxable by the IRS

One question we often hear is why file for bankruptcy if there is a chance that you can negotiate with your creditors to reduce or even eliminate debt on your own? Although the chances of getting a creditor to completely wipe out debt without making any payment is possible, and sometimes creditors will spontaneously waive debt (usually older debt), there are things you should know about the consequences of that happening.

Taxable Income

The biggest consequence is that debt that a creditor forgives—whether they do so on their own, or whether you negotiate to wipe out or waive the debt (even part of the debt)—is considered income for IRS purposes. If Chase bank waives a $5,000 bill you incurred with them, the IRS considers that like you making an extra $5,000 (even though you obviously don’t magically have that amount in your pocket).

That includes income from a mortgage—so if you are foreclosed on, and your home is “upside down” (negative equity), and the lender agrees to waive the balance, you could end up with hundreds of thousands of dollars in taxable income.

Granted, the taxes on discharged debt are always less than the actual debt, so you’re still coming out ahead. The negative is that you’d probably prefer to owe money to a private creditor like a bank than owing the IRS, which has many more methods to collect.

Bankruptcy Discharges

This is where bankruptcy gives debtors a huge advantage—debts that are discharged in bankruptcy are not considered taxable income by the IRS. Discharged debt can reduce certain tax benefits that people may receive, such as basis reductions, capital loss carryovers, or foreign tax credits—but as you can see, most of these won’t even apply to the everyday bankruptcy filer.

You can even fill out or ask a tax professional to fill out a form (Form 982) with your tax return after your discharge. This form tells the IRS that you filed for bankruptcy and not to treat discharged debt as income to you.

After your discharge, some creditors will still issue you a 1099-C, a form that indicates that debt has been “cancelled” (and is thus taxable). However, this doesn’t change the fact that if the debt was discharged in the bankruptcy, the discharged amount is not considered taxable as it would be if it were excused or waived outside of bankruptcy.

If you have older debt, you may want to think about filing for bankruptcy sooner. If a creditor issues a 1099, and excuses the debt before you file your bankruptcy, it’s now income, and it is taxable.

Make sure you have an attorney to help you with your fresh start after bankruptcy. Call the West Palm Beach bankruptcy lawyers at Kelley Kaplan & Eller at 561-264-6850 for help and guidance with your bankruptcy discharge.

Resource:

irs.gov/taxtopics/tc431