Does Bankruptcy Create Taxable Income

Section 108 of the Internal Revenue Code provides that as a general rule the cancellation of indebtedness creates taxable income.

Example

 Holly Hamilton has missed a number of payments on her credit card issued by the Thirteenth National Bank of Mundelein Illinois. With the higher interest rates that kick in, when one fails to make minimum credit card payments, she soon has rolled her debt up to $20,000. When the credit card company offers to settle for half this amount, Holly quickly borrows $10,000 from her mother and pays off her debt. She assumes this is the end of the matter and is quite pleased with the result. However, at the end of the year the Thirteenth National Bank sends a 1099 form to the Internal Revenue Service reporting that Holly has $10,000 of cancellation of indebtedness income, and though the bank also sends her a copy of the 1099, she does not understand the document and ignores it when she prepares her annual tax return. Later that year Holly receives a letter from the Internal Revenue Service demanding several thousand dollars of taxes and penalties.

There are however several exceptions to this general rule, and one of these exceptions is  bankruptcy.  If Holly had gone to a bankruptcy lawyer and had received a discharge of the $20,000 debt in a Chapter 7 bankruptcy she would have no tax liability on the transaction.

Another exception provides that the taxpayer will not recognize taxable income on cancellation of indebtedness to the extent he or she was insolvent at the time of the cancellation of indebtedness. A person is insolvent if immediately before the cancellation of the debt the person’s liabilities exceeded the fair market value of his property. In Holly Hamilton’s case the fact that she had to borrow the money from her mother to settle her credit card debt for fifty cents on the dollar is a strong indication that she was insolvent, and she may well be able to avoid the tax liability, even if she does not file bankruptcy.

One thing to keep in mind is that, since the bank reported the income to the Internal Revenue Service, the government will still demand the tax unless Holly claims the insolvency exception on her tax return. She does this by completing form 982 and submitting it with her 1040. Creditors should not report the taxable income to the government in the case of bankruptcy discharge; however, sometimes they do, in which case the debtor also needs to claim the exception when she files her tax return. :