Be Careful: Canceled Debt Is Taxed As Income

Many consumers are unaware that the cancellation or forgiveness of debt is considered taxable income by the IRS. For example, if your lender agrees to forgive $50,000 of your mortgage through a short sale, your taxable income will increase by the amount forgiven. This means that the IRS will send you a tax bill for the amount of debt you think has been forgiven.

Bankruptcy Is The Exception

By contrast, the discharge in bankruptcy has no tax consequences. See also: What Does It Cost To File Bankruptcy?
The Internal Revenue Code § 108 excludes the discharge of debt in bankruptcy from its definition of cancellation of debt income as follows:

(a)  Exclusion from gross income
(1) In general
Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—
(A) the discharge occurs in a title 11 case,
(B) the discharge occurs when the taxpayer is Insolvent,
(C) the indebtedness discharged is qualified farm indebtedness,
(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2010.

Outside of bankruptcy, cancellation of debt may be treated as if it were income for tax purposes.  If you have received an IRS 1099(c) on a debt discharged in a bankruptcy case, you can file Form 982 to tell the IRS that the sum on the 1099 should be excluded from your income by reason of your bankruptcy.

A Note On Loss Carry Forwards

Note that the debtor’s tax attributes, such as loss carry forwards and exclusion of gain on sale of a primary residence, as they exist before bankruptcy, pass to the bankruptcy estate and may be used or even exhausted by the Trustee in the administration of the estate.

It is important to get professional tax advice before venturing into bankruptcy if your tax situation is complex.  The IRS provides useful information in its online publication on bankruptcy and tax. This publication covers the federal income tax aspects of bankruptcy. However, this publication is not intended to cover bankruptcy law in general, or to provide detailed discussions of the tax rules for the more complex corporate bankruptcy reorganizations or other highly technical transactions. Additionally, this publication is not updated on an annual basis and may not reflect recent developments in bankruptcy or tax law. For these reasons, the advice of a tax professional is necessary in some cases.

See also: Debt Settlement Tax Consequences: Three Rules To Remember

Erik Clark

Erik Clark is one of the leading bankruptcy attorneys in Southern California who has had the privilege of representing thousands of clients in chapter 7 and chapter 13 bankruptcy cases in the Los Angeles area. Erik has served as the past President of the National Consumer Bankruptcy Litigation Center (NCBLC) and the American Consumer Bankruptcy College (ACBC). His firm, Borowitz & Clark, is committed to using bankruptcy law as a tool for social justice and was one of the first consumer law firms to join the Law Firm Antiracism Alliance.
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