Bankruptcy eliminates tax consequences for cancellation of debt

Cancellation of Debt

In the current slow economy, many Americans are struggling to make ends meet. Individuals are over their heads in expenses and debt. The good news is that some financial institutions will discharge some payment obligations, thus eliminating one's duty to repay certain loans. However, the bad news is that generally, discharged debt qualifies as realized wealth, which is taxable income under federal law. Therefore, one must usually pay taxes on any relieved debt.

In the year that the cancellation of debt occurs, the lender reports the released debt to the debtor and the Internal Revenue Service. The IRS report is typically on a 1099-C form, which is used for debt forgiveness. Under general tax law, the discharged amount is factored into in one's taxes. Thankfully, there are some exceptions to this rule, which relate to bankruptcy proceedings.

Tax Exclusions for Discharged Debt: Title 11 Bankruptcy

If the borrower is undergoing Title 11 bankruptcy when the debt is discharged from a lender, this accession of wealth will be exempt from tax consequences. This is because discharged debt is not realized in bankruptcy cases under section 108 of the United States Code.

The following bankruptcy filings are under the ambit of Title 11:

  • Chapter 7 liquidations
  • Chapter 11 reorganizations
  • Chapter 13 wage earner filings

Generally, Chapter 7 liquidation eliminates a majority of unsecured debt, including credit cards, medical expenses and other personal loans. On the other hand, Chapter 11 reorganization is intended for businesses. This process addresses debt through business restructuring and a detailed financial plan. In Chapter 13 bankruptcy, debtors keep all possessions and consolidate debt. They also make periodic payments on loans.

Relief of Tax Consequences

Once debt has been canceled in a bankruptcy case, one must verify this discharge with the IRS. To ensure that the debt relief will not be included in taxable income, one should attach Form 982 to his or her federal income tax return.

Debtors can only invoke this tax exclusion if the cancellation of debt is granted under the jurisdiction of the court in the form of an order or approved bankruptcy plan. Overall, there are many debt-reducing options for those undergoing financial strain. If you are plagued by monetary responsibilities, you may want to consult with an experienced bankruptcy attorney about opportunities for relief. The available options may address your problems and simultaneously relieve tax payments.