In contrast, if your debts are forgiven or settled outside of bankruptcy, the forgiven amount may be added to your income and subject to tax.
That’s called cancellation of debt income.
Debt forgiven in bankruptcy, however, doesn’t trigger cancellation of debt income.
The tax free feature of bankruptcy is one very compelling reason why bankruptcy may be a better choice than debt settlement.
It is also a reason to file bankruptcy when facing a foreclosure even if you intend to let the house go. A foreclosure may generate taxable income measured by the difference between the value of the property and the amount owed on the mortgage.
The Internal Revenue Code §108 excludes the discharge of debt in bankruptcy from its definition of taxable income. Outside of bankruptcy, cancellation of debt may be treated as if it were income for tax purposes.
Note that if your debt is discharged in some fashion outside of bankruptcy, you still may be able to escape the tax if you are insolvent. Beware, however, that the IRS’s calculation of insolvency include your retirement savings as assets for this purposes.
Got a Form 1099?
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.
There’s a box to check; it’s simple.
Tax attributes in bankruptcy
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.
Get good tax advice before venturing into bankruptcy if your tax situation is complex. There’s good stuff on the subject in IRS publication on bankruptcy and tax.
Read more on taxes & bankruptcy
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