Tax Implications of Bankruptcy

Most people don’t realize that there can be a tax implication when debt is forgiven by a creditor until they file their next tax return. By then, it’s too late to do anything to lower the tax burden. Most will approach their creditors (banks, credit card companies, mortgage lenders) with an offer to only pay back a portion of the debt owed. If any amount of that debt is forgiven (written off), then it becomes income to the taxpayer, and taxes are owed on that amount. While it will be less costly for the taxpayer to pay the tax on that income instead of the debt itself, there are ways to avoid paying the tax, as long as the taxpayer does this before the end of the tax year.

One way is to declare bankruptcy. This discharges the debt with no tax implications. The law specifies that a discharged debt cannot be collected by any creditor, and this includes tax liabilities. Often the taxpayer has a house that is foreclosed on, and the taxpayer then becomes “upside down” on the mortgage – meaning they owe more than the house is worth. If that debt is forgiven, it too becomes income and must be claimed on the tax return. If the Debtor is in that situation they should consider filing either a Chapter 7 or Chapter 13 bankruptcy, and have the debt discharged instead of reported to the IRS as income.

Federal bankruptcy provides an exception to the taxable income rule when debt is forgiven. In fact, the debt is discharged by the Federal court. Any debt that is forgiven or settled outside of the bankruptcy court is still taxable.

If you are facing foreclosure or bankruptcy, call on two professionals to help you out. First, contact a lawyer to make sure everything is filed in concurrence with Federal guidelines, and that bankruptcy is the best course of action. And then call your tax preparer at PRO-TAX – we will help you file the return to make sure you are not paying additional income tax that could be waived under the Bankruptcy laws.

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