Why Debts Discharged in Bankruptcy Are Not Taxable Income

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You might have heard the Internal Revenue Service considers canceled debts or debts discharged to be income and that you must report that income on your tax return. You heard wrong, at least to some extent. This isn't a blanket rule that applies to all debts discharged.

A forgiven or canceled debt is one where the creditor agrees to or is prohibited from pursuing you for the money. You no longer owe it. These debts are usually not considered income if that happens as part of a bankruptcy proceeding, but "usually" is the key word here.

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. 

How to File Debts Discharged in Bankruptcy

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

Be sure to attach the form because the lender is also obligated to submit a copy of Form 1099-C to the Internal Revenue Service. It could raise a flag if you simply don't include the amount on your tax return without any supporting explanation or documentation. 

How to Report Debts Discharged Before You Filed for Bankruptcy 

Timing is everything. You must include the amount of the debt stated on Form 1099-C on your tax return if the lender filed it with the IRS before you file for bankruptcy to get the most benefits. 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.

How to Avoid Filing for Bankruptcy With a Loophole

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 loophole? 

Canceled debts are excluded from income when they're made as gifts. This includes inheritances, such as if a kind family member forgives a debt you owe him in his last will and testament.

Other Exceptions to Rules on Debts Discharged in Bankruptcy

Debts can also 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 that was 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 if the lender cancels a $15,000 debt, the difference becomes taxable income if your insolvency is only $10,000. 

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.

If that canceled debt is associated with a foreclosure, you don't have to count this as income either, as of 2017. The Mortgage Debt Forgiveness Act technically expired at the end of 2016, but the Bipartisan Budget Act of 2018 extended it retroactively through the end of 2017.

The mortgage had to be on your principal residence. According to bankruptcy lawyers, the law allows you to exclude from income up to $1 million in debt and $2 million in this case if you're married and you file a joint return. 

How to Report Debts Discharged in Bankruptcy If You Have to Claim the Taxable Income 

Enter the amount of the canceled debt on line 21 of your 1040 if you must report it as income. It's "other income" and Form 1040 provides a small area where you can explain the source, which would be "canceled debt". But, don't do this until after 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.