Imagine this scenario: you’ve filed a Chapter 7 bankruptcy, and after you’ve received your bankruptcy discharge wiping out your debts, you receive a 1099-C from a creditor. A 1099-C stands for “Cancellation of Debt” income because under normal circumstances, if a creditor forgives a debt you owe, it will be counted as income to you that must be reported to the IRS or your state taxing authority. So the question we are often asked is whether income reported to the IRS by a creditor on a 1099-C on a discharged debt is actually taxable income for federal or state tax purposes.
Debts Discharged in Bankruptcy Are NOT Considered Taxable Income
Fortunately, debts that you wipe out in bankruptcy are NOT considered income to a taxpayer. Mortgage companies will often send out a 1099-C to a taxpayer that has discharged an old mortgage debt out of an abundance of caution, but it doesn’t mean it’s going to be counted by the IRS as income.
While a debt forgiven outside of bankruptcy is taxable income, there is an exception to this rule pursuant to Internal Revenue Code Section 108 which provides that debts discharged in a bankruptcy case do NOT need to be included as income for forgiveness of debt.
Even though debts discharged in a bankruptcy are not counted as taxable income to a debtor, the amount of debt discharged can be used by the IRS to reduce certain tax attributes of the debtor such as net operating loss carryover, minimum tax credit, basis reduction in certain assets, foreign tax credits, and net capital loss and capital loss carryovers. This is not an exhaustive list, so please consult a CPA when it comes time to file your taxes after filing bankruptcy. Most of these tax attributes won’t apply to 99% of people who file bankruptcy. Your attorney will let you know if these issues should be taken into consideration at tax time.
If you want to make absolutely sure the IRS doesn’t improperly assess discharged debt as income, ask your accountant to file a Form 982 from the IRS with your return. IRS Publication 4681 gives detailed instructions on how to fill this form out and how to properly attach it to your tax return for the year after you filed bankruptcy.