What Happens When a Creditor Forgives a Debt?
One of the reasons people file Bankruptcy is to get a "discharge." A discharge is a Court Order, which states you do not have to pay most or all of your debts. A discharge means you no longer have liability on the debts.
Despite a Bankruptcy discharge, some creditors may list the debt as "cancelled" or "forgiven" and report this activity with the IRS. If you do not make payments on a loan secured by property (such as your vehicle or home), the lender may repossess the property or foreclose on the loan. Theforeclosure or
repossession is treated as a sale or exchange form which you may realize a gain or loss for tax purposes. You may realize ordinary income from cancellation of debt if the loan balance is more than the fair market value of the property.
If your creditor formally claims this forgiveness with the IRS, you may have to include the cancelled amount as income on your tax return. This could lead to problems with the IRS and defeat the purpose of filing for Bankruptcy.
There are several situations in which you do not have to include the cancelled amount as income, but these exclusions are not automatic. First, you must submit IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness). The IRS will also require a copy of all Bankruptcy documents.
The best way to exclude the cancelled debt is to prove you were insolvent at the time of discharge. This time period will depend on the Bankruptcy you file (approximately 6 months after filing for
Chapter 7; between 3 to 5 years after filing for
Chapter 13). The IRS will require a breakdown of your total assets and liabilities immediately before the debt was discharged.
You are considered insolvent to the extent your total liabilities exceeded your total assets. For example, if your liabilities totaled $20,000 and your assets totaled $10,000, you were insolvent by $10,000. Debt cancellation is then excludable up to the insolvent amount. If the forgiveness of debt exceeds the amount of your insolvency, you will be required to include the cancelled debt (unless another exception under the Tax Code applies). For more information on these topics, it may be beneficial to visit the IRS website at: www.irs.gov.
If you are considering Bankruptcy, please call us at: (713) 893-6204. The
Law Office of Nicholas R. Westbrook offers FREE consultations at various locations around Houston. Mr. Westbrook is a
Houston Bankruptcy Attorney who will review your situation and explain all available options. You may be able to eliminate or significantly reduce your debts. It may be necessary to speak with a certified accountant to discuss the tax implications of filing for Bankruptcy - and whether you will be eligible for the cancelled debt exclusions under the Tax Code. Our office can recommend a good accountant for this purpose. Call us today. Stop letting debt ruin your life.