Be Careful: Canceled Debt Is Taxed As Income
Bankruptcy Is The Exception
(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.
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.
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.