Bankruptcy

Debt Canceled v. Discharged: A Taxing Matter

By Mark Buckley, Rhode Island Bankruptcy Lawyer

Under the US Bankruptcy Code, if a debt is discharged in a bankruptcy case, it does NOT count as taxable income.  Bankruptcy-discharged debt is, therefore, much more powerful than merely canceled debt.  While canceled debt usually creates an income tax liability, discharged debt does not.

CANCELED DEBT SOUNDS GOOD

We all know that wage income is taxable.  Take a look at your latest paystub 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 “canceled debt” I mean that portion of a debt that a creditor is unable to collect from you and is later ”written off.”  Its that pile of bills you have no ability to repay and is basically uncollectible.

First, lets consider some examples.  What if you borrow $ 100,000 from a bank and then default after only repaying $ 20,000?  How should the $ 80,000 unpaid portion be treated by the IRS? Here is another example. If you owe $ 8,000 on a Visa credit card and stop making payments, how should the creditor’s loss be treated on your 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, you receive your 1099-C and report the canceled debt as additional income subject to the tax ax.

This is why many debt management, or debt consolidation programs are dangerous.  While they may be marginally successful in getting your phone to stop ringing from debt collectors, they cannot prevent the IRS from knocking on your door wanting to tax you on the canceled debt.

DISCHARGED DEBT IS 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.

In a future post, we will consider the Mortgage Forgiveness Debt Relief Act of 2007.  While the act will not prevent a mortgage company from suing you, it may remove the tax liability of canceled debt for a homeowner on his principal residence.

Full post as published by Bankruptcy Law Network on March 27, 2010 (boomark / email).