Debts Cancelled in Bankruptcy are Not Taxable Income

Do You Have to Pay Taxes on Cancelled Debts?

A reader recently told me that he had filed for bankruptcy and he wondered how his erased debts would affect his taxes. He'd heard that he must claim his cancelled debts as income on his Form 1040. 

Not so. Debts discharged in a bankruptcy proceeding aren't usually considered taxable income. But "usually" is the key word here, and if you have a debt forgiven outside of bankruptcy, the rules change.

If you filed for bankruptcy last year or had one or more debts forgiven, here's what you need to know as you get ready to file your tax return. 

Debts Canceled in Bankruptcy 

"Taxpayers who file for bankruptcy are generally not required to include cancelled debt in taxable income," explains Cindy Hockenberry, 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 cancelled 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 Sec. 108."

Debts Cancelled Before You File for Bankruptcy 

Your timing is everything, however. If you receive a 1099-C and it's been filed with the IRS before you file for bankruptcy, you must include the amount of the debt stated on the form on your tax return.

Why? Because it's not a debt any longer. 1099 forms memorialize various kinds of income you've received during the year, so the debt is now income — you've borrowed money that you don't have to pay back. It's yours now, even if you've already spent it. Bankruptcy can only cancel debts. It doesn't erase income.

 

If You Don't File for Bankruptcy 

According to the IRS in Publication 525, "Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. You have no income from the canceled debt if it is intended as a gift to you. A debt includes any indebtedness for which you are liable or which attaches to property you hold." Wait — what's that about a gift? 

Canceled debts are excluded from income under certain other circumstances, including when they're made as gifts. They can also be excluded from your income if it's determined that you're insolvent — the total of your debts exceeds the total fair market value of your assets 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 that was cancelled. If your debts exceed the fair market value of your assets by $10,000, and if a lender forgives $10,000 in debt or less, you're fine. But if the lender cancels a $15,000 debt, the difference — $5,000 — becomes taxable income if your insolvency is only $10,000.  

If You Have to Claim the Income 

Enter the amount of the cancelled debt on line 21 of your 1040 — but not until after you consult with a tax professional about the exact details of your situation and it's determined that you have to.