Taxation of Debts Cancelled in Bankruptcy

Most residents of Rockland County have never heard of cancellation of indebtedness income. The common perception is that when a creditor cancels a debt, that’s it. The debtor is completely off the hook, and nothing more needs to be done. Unhappily, that is not the case.

The federal tax code says that, when a debt for which the taxpayer is personally liable, such as a credit card debt, is cancelled by the creditor, the taxpayer must include the canceled portion of the debt in gross income. In other words, if the taxpayer owes $5,000 on a credit card, for example, and the card issuer forgives the debt, the taxpayer now has gross income of $5,000 that must be reported to the IRS. Most creditors who forgive a portion of the amount owed to them will send a form 1099-C to the taxpayer and to the IRS. Many kinds of debts are exempt from this requirement, which raises the question: Do debts discharged in bankruptcy create cancellation of indebtedness income?

The plain answer is “no.” Debts that are cancelled in any type of bankruptcy proceeding do not constitute cancellation of indebtedness income. The debtor musts be under the jurisdiction of the federal bankruptcy court and the cancellation of the debt must be ordered by the court pursuant to a plan of liquidation or under a plan of reorganization approved by the court. In order to claim the exclusion, the taxpayer must attach Form 982 to tax Form 1040. Debts that are forgiven while the taxpayer is insolvent are likewise excluded from the definition of cancellation of indebtedness income. “Insolvency,” in this case, is defined as having debts whose total amount exceeds the fair market value of the debtor’s assets.

If a person owes more than one debt that is being forgiven in bankruptcy, the advice of an experienced bankruptcy attorney may help avoid mistakes in reporting the forgiveness or in claiming the exemption for insolvency.