In general, debt discharged in bankruptcy is not taxable and most people who file for consumer bankruptcy have no tax consequences as a result of the bankruptcy filing. However, there are a few areas in which you should be aware of the interaction between bankruptcy and tax liability.
Loss Carry Forward/Exclusion of Gain on Sale
When you file for bankruptcy an estate is created. This means that all your assets become property of the bankruptcy estate and if they are not exempt then they can be liquidated by the bankruptcy trustee for the benefit of your creditors.
Sometimes, especially in the case of the small business owner or someone who has recently sold real estate, there are positive tax attributes that will be lost with the filing of bankruptcy. If you have suffered losses that you are allowed to take as deductions on your taxes, you should use the maximum amount possible –even if that means going back to amend a prior year to take losses you elected to save for later. There are two reasons for this.
The first reason is that the loss carry forward is an asset in a bankruptcy case and the trustee can step into your shoes and use the loss carry forward, even going back and taking in on a prior year. In most jurisdictions, including Colorado where I practice bankruptcy law, the extra refund created by taking the losses is not exempt and will be given to creditors. The second reason is that your right to take losses in the future will be reduced by the amount of debt discharged in your bankruptcy. This usually means that even if the trustee doesn’t take the extra refund, it will disappear as a result of the bankruptcy filing.
There are other tax attributes which can be lost as a result of filing bankruptcy, including: minimum tax credit, basis (which can be reduced as a result of discharged debt) and foreign tax credits. For more information on bankruptcy and tax attributes, see IRS Publication 908.
1099C/Cancellation of Debt Income
One way bankruptcy can help you with your tax liability is in the area of cancellation of debt income. Normally, when you settle a debt for less than its full value whether it comes from a negotiation with the owner of your credit card debt, a short sale or some other situation where you pay less than the full amount owed on a debt, the difference between what you owed and what you actually paid is considered income for tax purposes. This type of income is called Cancellation of Debt Income and is usually accompanied by the issuance of a 1099C tax form, which is reported to the IRS.
Luckily, bankruptcy is a complete defense to the 1099C income issue. If you filed bankruptcy, debts included in your bankruptcy do not result in debt forgiveness income. Additionally, insolvency is a defense to the 1099C issue as well. This means that if your liabilities (debts) equals more than the fair market value of your assets you are technically insolvent and cannot be held liable for tax penalties on forgiven debt even for debts reduced outside of bankruptcy.
IRS Form 982 Is Your Friend
Sometimes, even though you file for bankruptcy, your past creditors still submit a 1099C to the IRS. This is an easy situation to handle, especially if your tax preparer is familiar with bankruptcy’s effect on forgiveness of debt income. All you need to do is submit IRS Form 982 along with your taxes and you will not have to pay taxes on the discharged debts in your bankruptcy.