Will I have to pay taxes on the debt discharged in my bankruptcy?

It’s tax season. Many folks in the Sacramento area have already filed their tax returns, but there are still a lot of people who will be filing their taxes over the next 10 days. One question that often comes up in the context of bankruptcy is whether all that discharged debt is taxable as “gross income.”

Fortunately, the law is quite clear on this subject. Generally speaking, the discharge of debt in bankruptcy is not included in gross income for tax purposes. The Internal Revenue Code provides that gross income does not include any amount which would be includable in gross income by reason of indebtedness of the taxpayer if the discharge occurs in a bankruptcy case. 26 U.S. Code Section 108(a)(1)(A). The 1099-C form actually says on the back-side that “debts cancelled in bankruptcy are not includable in your income.”

Despite the law being so clear on this point, creditors still sometimes send a debtor a 1099 Form when a debt is discharged in bankruptcy. To be fair, there may be confusion about whether the debt was discharged in bankruptcy or prior to the filing of the bankruptcy. For example, when a deficiency is forgiven in connection with a deed in lieu of foreclosure. (more on this subject below) So, due to creditors being easily confused and inattentive to rights of consumers, this issue will probably continue in perpetuity.

This is not just a legal problem that doesn’t affect normal folks. In fact, it can cause serious harm to debtors who are working hard to repair their credit, fix their financial situation and care for their families. If the tax preparer has little experience, like almost everyone who files their own taxes, they will see the 1099 form and just assume that the debt is taxable and include it in the tax return. This could very easily lead to a consumer paying taxes which are not owed. Paying taxes is already painful. Paying taxes you don’t owe is much worse.

As mentioned above, it can be tricky to deal with taxability when a debt is forgiven prior to bankruptcy, like in the case of a deed in lieu of foreclosure or other similar foreclosure resolutions. Generally, a debt forgiven prior to filing for bankruptcy is going to be a taxable event. However, there may be other reasons it’s not taxable, like if the consumer is insolvent. 28 U.S. Code Section 108(a)(1)(B).

These common legal issues and many others are all very good reasons to do your research and consult an experienced professional. It’s spring time and summer is right around the corner. It is a wonderful time of year. It just makes good sense to consult a knowledgeable bankruptcy attorney to help navigate these legal waters. That way you can focus on recreation, like floating down the American River or strolling in Old Sacramento, free of stress.