Normally, a forgiven debt is not a total gift, because the IRS considers it income, but not in the case of a bankruptcy discharge. Taxing bankruptcy discharges would run counter to the purpose of bankruptcy: getting someone out of a cycle of debt. Declaring bankruptcy may, however, have other negative implications on federal taxes, such as the elimination of some deductions.
How Bankruptcy Works
When a person files bankruptcy, the bankruptcy court creates a taxable entity that contains all of the person's assets. Any exempt property is then removed from the taxable estate. Thus, the debtor is responsible for paying taxes on not just his income, but also exempt assets. The IRS excludes bankruptcy discharges from your taxable income, but the trustee may use assets in the estate to pay federal taxes on the bankruptcy estate, according to the IRS website.
The filer must report canceled debt to the IRS after the bankruptcy filing and under the protection of the bankruptcy court. Also, the debtor probably cannot claim the expenses associated with filing a bankruptcy on his taxes, such as the fees for bankruptcy and any administrative costs.
You May Need to File Form 982
Creditors may try to collect on a debt after a bankruptcy and send you a 1099-C, used to report canceled debt. If this happens, you need to file IRS form 982 and state that the canceled debt should not be included in your taxable income because a bankruptcy court discharged it. If the bankruptcy estate contains any taxable income, the trustee in charge of the case files a return for the estate and pays its taxes.
Bankruptcy and debt management plans are not the same thing, even though debt management is often suggested to avoid bankruptcy. If a creditor forgives debt, the IRS will tax it. Thus, consumers should weigh the effects of a bankruptcy, such as destroying your credit score, with the cost of paying taxes on forgiven debt. In some cases, you can avoid taxes on canceled debt outside bankruptcy. In 2007, for example, Congress temporarily eliminated taxes on short sale deficiencies.