What Are Tax Consequences Of Discharging Debt In Bankruptcy

There are Tax Consequences Of Discharging Debt. It centers around if its discharged in a bankruptcy or outright written off by the creditor. It also centers around the kind of bankruptcy you filed. This is because a chapter 7 forgives the debt outright while a chapter 13 does not. Below, we’ll explore this critical issue to help you make an informed decision about your financial future.

What Is Discharge Of Debt In Bankruptcy?

Before we delve into the tax consequences, it’s essential to understand what discharging debt in bankruptcy means. When you file for bankruptcy, certain debts may be discharged, or wiped out, meaning you are no longer legally obligated to pay them. Discharging debt is the primary reason people turn to bankruptcy. When they do they file under Chapter 7 and Chapter 13 bankruptcy. This is the most commonly used bankruptcy laws in the U.S. These laws provide a fresh start to individuals struggling with overwhelming debt, but they come with their share of consequences, one of which involves taxes.

Are Discharged Debts Considered Taxable Income?

The general rule, according to the Internal Revenue Service (IRS), is that canceled, forgiven, or discharged debts are considered taxable income. This is outlined in Title 26 U.S. Code § 61(a)(12). This means that if a creditor forgives a debt you owe, the IRS typically considers that amount as income you’ve received. This is done the same way gambling winnings are also reported as income. However, there’s a notable exception to this rule for debts discharged through bankruptcy.

Exception For Bankruptcy: Title 26 U.S. Code § 108

Title 26 U.S. Code § 108 details exclusions from gross income, specifically regarding discharge of indebtedness. Under this law, if you discharge your debt under Title 11 of the U.S. Code (the Bankruptcy Code), that amount isn’t included in your gross income for tax purposes.

This exception was designed to prevent those filing bankruptcy from being burdened with a significant tax liability at a time when they’re seeking financial relief.

Understanding Insolvency: Another Tax Exemption

Another crucial factor to consider is the concept of insolvency. Under Title 26 U.S. Code § 108(a)(1)(B), if you are insolvent when the debt is canceled, some or all of this canceled debt may not be taxable. Insolvency occurs when your total debts exceed the fair market value of your total assets. This insolvency exception can be a bit complex to navigate.

Debt Discharge And Forms 1099-C

If a debt of $600 or more is discharged outside of bankruptcy, your creditor is required by law to send you and the IRS a Form 1099-C, Cancellation of Debt, at the end of the tax year. This form shows the amount of debt forgiven and the date of the cancellation. However, if the debt is discharged in bankruptcy, creditors are not required to send Form 1099-C, but some still might. If you receive a Form 1099-C following a bankruptcy discharge, consult with a bankruptcy lawyer. They may be able to avoid mistakenly reporting the discharged debt as income on your tax return.

The Bottom Line

While bankruptcy can provide significant relief for individuals struggling with unmanageable debt, it’s essential to understand all implications. Those implications includ tax consequences. Our our Oklahoma bankruptcy law firm is ready to assist you every step of the way. If you’re considering filing for Chapter 7 or Chapter 13 bankruptcy, contact Kania Law Office at (918) 743-2233 or contact us online today for a consultation.