Are Debts Discharged in Bankruptcy Considered Taxable Income?

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.

This rule applies whether you filed Chapter 7 bankruptcy, Chapter 13 bankruptcy, or even Chapter 11 bankruptcy. The key is that the debt must have been formally discharged through the bankruptcy court.

Why Do Creditors Send 1099-C Forms After Bankruptcy?

Many of our clients are surprised and concerned when they receive a 1099-C in the mail after their bankruptcy case has closed. There are a few reasons creditors send these forms:

• IRS reporting requirements: Creditors are required to report cancelled debts over $600 to the IRS
• Abundance of caution: Many creditors, especially large mortgage servicers, send 1099-C forms for any cancelled debt regardless of the reason
• Automated systems: Large creditors often have automated systems that trigger 1099-C forms whenever a debt is written off

Receiving this form does not change the tax treatment of your discharged debt. It simply means you need to properly report the exclusion on your tax return.

Tax Attributes That May Be Affected

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
• 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.

Protecting Yourself with IRS Form 982

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 (Reduction of Tax Attributes Due to Discharge of Indebtedness) 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.

On Form 982, you'll check the box indicating that the debt was discharged in a Title 11 bankruptcy case (Box 1a). This creates a clear paper trail showing the IRS that your discharged debt is excluded from taxable income.

What If I Already Filed Without Form 982?

If you've already filed your tax return without Form 982 and later receive a notice from the IRS treating your discharged debt as income, don't panic. You can:

• File an amended return (Form 1040-X) with Form 982 attached
• Respond to the IRS notice with documentation of your bankruptcy discharge
• Contact a tax professional or your bankruptcy attorney for assistance

The IRS generally accepts proof of bankruptcy discharge as sufficient documentation to exclude the debt from income.

The Bottom Line

Don't let a 1099-C form cause unnecessary worry after your bankruptcy. The tax code specifically protects bankruptcy filers from having to pay taxes on discharged debts. By proactively filing Form 982, you create a clear record that the debt was discharged through bankruptcy and should not be treated as taxable income. This can help prevent potential issues with the IRS down the road and give you peace of mind during tax season.

If you have questions about how bankruptcy might affect your tax situation, or if you're considering filing bankruptcy in Georgia, contact our office for a consultation with one of our experienced bankruptcy attorneys.