Generally speaking, the Internal Revenue Service (IRS) considers forgiven debt as income. For example, in debt settlement, the difference between the amount you owed and the amount you paid in the settlement is income and is supposed to be reported on your tax return as such. This means you may be subject to IRS taxes liabilities on the amount of the forgiven debt unless an exclusion applies. Bankruptcy is one such exclusion.
Cancellation of Debt
The IRS states: “In general, if you have cancellation of debt income because your debt is canceled, forgiven, or discharged for less than the amount you must pay, the amount of the canceled debt is taxable and you must report the canceled debt on your tax return for the year the cancellation occurs.”
The creditor will send you a Form 1099-C Cancellation of Debt for the tax year that the debt was canceled. The 1099-C will show the amount of cancellation of debt, the date of cancellation, and other pertinent information. Typically creditors will send this Form whenever they handle a transaction that involves a cancellation of debt. However, receiving a 1099-C for cancellation of debt does not mean it is necessarily a taxable event. Your creditor is merely reporting to the IRS. It is up to you to determine whether the canceled debt is taxable income or if an exception applies to your situation.
Note that whether or not you receive a 1099-C, it is “[y]our responsibility to report the taxable amount of canceled debt as income on your tax return for the year when the cancellation occurs[.]”
How Debts Are Canceled
Debts may be canceled (forgiven) in various ways, such as through debt settlement, agreement to compromise a debt, in a short sale or foreclosure, or in a bankruptcy.
There are exclusions to recognizing a debt-forgiving transaction as income. If an exclusion applies to your situation, then you do not have to include the amount of forgiven debt in your gross income.
The exclusions from gross income include:
- Bankruptcy Case Exclusion: The cancellation takes place in a bankruptcy case under the Bankruptcy Code.
- None of the debt canceled in a bankruptcy case is included in the debtor’s gross income in the year it was canceled.
- This exclusion only applies if cancellation of the debt is granted by the court or occurs as a result of a Chapter 13 plan approved by the court.
- Insolvency Exclusion: The cancellation takes place when the debtor is insolvent, and the amount excluded is not more than the amount by which the debtor is insolvent.
- A debtor is insolvent when, and to the extent, the debtor’s liabilities exceed the fair market value of the debtor’s assets.
- Insolvency and the amount by which a debtor is insolvent is determined by the debtor’s liabilities and the fair market value of her assets immediately before the cancellation of the debt.
- Exclude from the debtor’s gross income debt canceled when the debtor is insolvent, but only up to the amount by which the debtor is insolvent.
NOTE: The foregoing is not tax advice and should not be construed as such. Contact your tax professional for advice and guidance.
Bankruptcy Forgives Debt Without Tax Consequences
Bankruptcy provides for cancellation (discharge) of debt without tax consequences. However, if you enter into transactions that cancel debt before filing bankruptcy, and those transactions create new tax debts, those debts are not dischargeable in bankruptcy. Newer tax debts cannot be erased in bankruptcy (though certain older tax debts can be erased).
Here at the Law Office of Barbara B. Braziel, we help people get out of debt. We are the premier bankruptcy law firm in Savannah, GA and we practice exclusively in bankruptcy law. Our experienced attorneys are committed to ensuring you understand the protections and benefits of bankruptcy and how filing with affect you and your family. We invite you to get to know us here and read about the clients we’ve helped here.
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