As a Waco Bankruptcy Lawyer and a Killeen Bankruptcy Lawyer, I am frequently asked if getting a discharge in a bankruptcy case will make a client incur a tax liability. Under the U.S. Tax Code, if a debt is discharged in a bankruptcy case, that debt forgiveness is not taxable income. However, if a creditor forgives a debt outside of bankruptcy, that is taxable income. Debt canceled outside of bankruptcy creates an income tax liability, but debt discharged in a bankruptcy does not create a tax liability.
Canceled Debt Sounds Good
We all know that wage income is taxable. Take a look at your latest pay stub and remind yourself just how much the government actually takes.
But what are the tax ramifications of canceled debt? Is canceled debt treated the same way as regular income? Will you end up owing the IRS because of a debt settled or canceled by a creditor?
By a “canceled debt” I mean that portion of a debt that a creditor is unable to collect from you and is latter “written off”. Its that pile of bills you have no ability to repay and is basically not collectible.
First, lets consider some examples. What if you borrow $100,000.00 from a bank and then default after only repaying $20,000.00? How should the $80,000.00 unpaid portion be treated by the Internal Revenue Service? Here is another example. If you owe $8,000.00 on a Visa credit card and stop making payments, how should the creditor’s loss be treated on your federal income tax return?
Generally, a creditor’s loss is your income gain. When a creditor loses hope of collecting a debt, they may cancel the debt and report the amount canceled to the IRS using form 1099-C (Cancellation of Debt). Then, when tax season arrives, the creditor sends you and the IRS a 1099-C form which reports the canceled debt to the IRS as income.
That is why may debt management, or debt consolidation programs are dangerous. While they may be marginally successful in getting your phone to stop ringing from the debt collectors, they cannot prevent the IRS from knocking on your door wanting to tax you on the canceled debt.
Bankruptcy Discharge Is Much Better
This is not to say that a creditor won’t still attempt to send a debtor with a bankruptcy discharge a Form 1099-C. The solution for one who has filed bankruptcy, however, is to file IRS Form 982. This can exclude the amount of discharged indebtedness from your gross income.
Don’t confuse “canceled” debt with “charged off” debt. A “charge off” means the creditor has removed the account from its active books and likely sent the account for collection or sold the account to a debt buyer. You may see “charge off” on your credit report, but that does not mean you don’t owe the debt. You still owe the money unless the debt was canceled with a 1099-C or the debt was discharged in bankruptcy.