Tax Consequences of Bankruptcy & Debt Cancellation

Whether a debtor incurs any income tax consequences when released from liability on a particular debt depends upon whether the debt in question was (1) discharged in bankruptcy, or (2) simply cancelled (or forgiven) by the creditor outside of bankruptcy.

Debts discharged in dankruptcy

A debt discharged in bankruptcy has no income tax consequences to an individual debtor, as it is excluded from a debtor’s gross income pursuant to Internal Revenue Code §108(a)(1)(A). Notwithstanding this, it is not uncommon for a debtor to receive an IRS Form 1099-C, Cancellation of Debt in connection with a debt discharged in bankruptcy. If this occurs simply file with your next tax return an IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, advising the IRS that the debt in question was discharged in bankruptcy. This form can be obtained at www.irs.gov, or from your tax preparer.

A debtor should be mindful of the fact that tax attributes, such as loss, carry forward, pass to the bankruptcy estate and may be used (or even exhausted) by a Trustee in the administration of the bankruptcy estate. In addition, if the debtor happens to be a Subchapter S corporation, consequences can flow to the individual shareholders if the Trustee sells assets of the S Corporation, as the income generated by the Trustee’s sale may be taxable to the shareholders and not the bankruptcy estate. This is because an S Corporation is not a tax-paying entity, and the bankruptcy estate generally assumes the taxpayer status of the debtor

Debts cancelled outside of bankruptcy

If you borrow money from a commercial lender and the lender later cancels or forgives the debt, the cancelled amount may have to be included as income for tax purposes. When you borrowed the money you had an obligation to repay it, so the loan proceeds did not have to be included as income. However, when the debt was subsequently forgiven, the amount received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. In these circumstances the lender is generally required to send out Form 1099-C, Cancellation of Debt to the debtor and the IRS and the unpaid portion of the loan proceeds then has to be reported as income, subject to several exclusions, including:

• Bankruptcy: As above noted, debts discharged in bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when a debt is cancelled, some or all of the cancelled debt may not be taxable. Insolvency is basically determined by a balance sheet analysis, with one being insolvent when their total debts exceed the fair market value of all of their assets. Assets include everything you own, including real estate, vehicles, furniture, life insurance policies, stocks and other investments, pensions, retirement accounts, personal and real property that serves as collateral for other debt and exempt assets which are beyond the reach of your creditors under the law. Normally, forgiven debt is not included as income to the extent that you are insolvent. To claim this exclusion you must complete and attach IRS Form 982 to your federal income tax return. Example #1 – Debtor has a $5,000.00 credit card debt cancelled at a time when his total debts were $15,000.00 and the fair market value (“FMV”) of his assets was $7,000.00. Accordingly, debtor was insolvent to the extent of $8,000.00 ($15,000.00 minus $7,000.00). Because the amount that debtor was insolvent exceeds the amount of the cancelled debt, debtor can exclude the entire $5,000.00 cancelled debt from income. Example #2 – Debtor has a $5,000.00 credit card debt cancelled at a time when his total debts were $10,000.00 and the FMV of his assets was $7,000.00. Accordingly, debtor was insolvent only to the extent of $3,000.00 ($10,000.00 minus $7,000.00). Because the amount of the cancelled debt exceeds the amount by which debtor was insolvent, debtor can exclude from income only $3,000.00 of the $5,000.00 cancelled debt.
• Cancelled Farm Debts: If (1) you incurred the debt directly in the operation of a farm, (2) more than half your income from the prior three years was from farming, and (3) the loan was owed to a person or agency regularly engaged in lending, the cancellation of “qualified farm indebtedness” is generally not considered taxable income.
• Non-recourse loans: In a non-recourse loan the lender’s only remedy in case of default is to repossess the property held as collateral. That is, the lender cannot pursue you personally in case of a default. Forgiveness of a non-recourse loan resulting from a foreclosure or repossession does not result in cancellation of debt income.
• Qualified Principal Residence Indebtedness: This exception was created by The Mortgage Debt Relief Act of 2007, and pertains to debt incurred in acquiring, constructing or substantially improving your principal residence and which is secured by your principal residence. Generally, this allows taxpayers to exclude from income the cancellation of debt on their principal residence, provided (1) the debt is forgiven in calendar years 2007 thru 2012, (2) the amount forgiven is less than $2,000,000.00, or $1,000,000.00 if married and filing separately, and (3) the debt cancellation is not due to any reason not directly related to a decline in the home’s value or the taxpayer’s financial condition. This exclusion applies only to debt incurred to buy, build or substantially improve your principal residence, or to refinanced debt incurred for said purposes. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for this relief. However, proceeds of refinanced debt used for other purposes, such as paying off credit card debt, do not qualify for this exclusion.

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This Law Firm proudly practices Bankruptcy Law, helping clients file cases under Chapters 7, 13 and 11. According to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, we are considered to be a Debt Relief Agency.