Why Debts Discharged in Bankruptcy Are Not Taxable Income

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You might have heard that the Internal Revenue Service (IRS) considers canceled, discharged, or forgiven debts to be income, and that you must report that income on your tax return. And that's true, at least to some extent. But this isn't a blanket rule that applies to all debts that are discharged.

Debts usually aren't considered to be income if they're discharged as part of a bankruptcy proceeding. The rules change if you have debts forgiven outside of bankruptcy, but in some cases, you don't have to report these as income either in some cases, either. 

A forgiven, canceled, or discharged debt is one that the creditor has agreed to or is prohibited from pursuing payment. You no longer owe it.

Debts Discharged in Bankruptcy

"Taxpayers who file for bankruptcy are generally not required to include the canceled debts in their taxable incomes," explains Cindy Hockenberry, an enrolled agent and tax information analyst with the National Association of Tax Professionals.

This is the case even if you receive a Form 1099-C from a lender showing the amount of the debt that's been canceled or discharged. Hockenberry advises, "Attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to your income tax return. This shows the IRS that the discharged amount is excluded from income under Code Section 108."

Be sure to attach the form because the lender is also obligated to submit a copy of it to the IRS. It could raise a flag if you don't include the amount on your tax return without any supporting documentation or explanation.

Debts Discharged Before Bankruptcy 

You must include the amount of the debt stated on Form 1099-C on your tax return if the lender forgave it and filed the form with the IRS before you filed for bankruptcy. It's not a debt any longer when this happens. It's now income—you've borrowed money you don't have to pay back.

Bankruptcy can only cancel debts that exist at the time you file. The debt is gone if you've already received a Form 1099-C. It's been turned into income, and bankruptcy doesn't erase income.

Canceled Debts That Are Gifts

The IRS indicates in Publication 525 that you don't have to include a canceled debt in your income if it occurs as a gift or a bequest. Debts are therefore excluded from income if a kind family member forgives money you owe them in their last will and testament, or if a kindly benefactor says, "Don't worry about it. You don't have to pay me back. Happy holiday."

Other Exceptions to Discharge Rules

Debts can be excluded from your income for tax purposes if you're insolvent—the total amount of your debts exceeds the total fair market value of all your assets. This is the case even if you haven't yet filed for bankruptcy to rectify the problem.

But here's another catch: The extent of your insolvency must be as great as, or more than, the debt or debts that were canceled. You're fine if your debts exceed the fair market value of your assets by $10,000 and a lender forgives $10,000 in debt or less, but the difference becomes taxable income if your insolvency is only $10,000 and the lender cancels a $15,000 debt. You'd have to report that additional $5,000.

Student loans are sometimes canceled if you work them off with certain employers. The IRS does not consider this to be income to you, either.

You don't have to count canceled debt as income, either, if it's associated with a foreclosure, at least through the end of 2020. The Mortgage Debt Forgiveness Act provided for this tax break, but the legislation expired at the end of 2016. Then the Bipartisan Budget Act of 2018 extended it retroactively through the end of 2017, and the Further Consolidated Appropriations Act of 2020 extends it through December 31, 2020. 

The mortgage has to be on your principal residence to qualify. The law allows you to exclude from income up to $1 million in debt, or up to $2 million if you're married and you file a joint return with your spouse.

The mortgage debt forgiveness provision in the tax code has died and been resurrected numerous times, so keep an eye out for further legislation that might breathe new life into it in 2021.

The Bottom Line

Don't report a discharged debt until you've consulted with a tax professional about the exact details of your situation. You want to be very sure that you do, indeed, have to report the income. Likewise, plan on including a debt as income unless and until a tax professional tells you that you don't have to.