Why Debts Discharged in Bankruptcy Are Not Taxable Income

The IRS considers canceled, discharged, or forgiven debts to be income, and you must report that income on your tax return. But this isn't a blanket rule that applies to all debts that are discharged. Debts usually aren't considered to be income if they're discharged as part of a bankruptcy proceeding. The rules change if you have debts forgiven outside of bankruptcy, but in some cases, you don't have to report these as income either.

Debts Discharged in Bankruptcy

"Taxpayers who file for bankruptcy are generally not required to include the canceled debts in their taxable incomes," said Cindy Hockenberry, an enrolled agent and tax information analyst with the National Association of Tax Professionals. This is the case even if you receive a Form 1099-C from a lender showing the amount of the debt that's been canceled or discharged.

"Attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to your income tax return. This shows the IRS that the discharged amount is excluded from income under Code Section 108," said Hockenberry.

Be sure to attach the form, because the lender is also obligated to submit a copy of it to the IRS. It could raise a flag if you don't include the amount on your tax return without any supporting documentation or explanation.

Debts Discharged Before Bankruptcy 

You must include the amount of the debt stated on Form 1099-C on your tax return if the lender forgave it and filed the form with the IRS before you filed for bankruptcy. It's no longer a debt when this happens. It's now income—you've borrowed money you don't have to pay back.

Canceled Debts That Are Gifts

The IRS indicates in Publication 525 that you don't have to include a canceled debt in your income if it occurs as a gift or a bequest. Debts are therefore excluded from income if a kind family member forgives money you owe them in their last will and testament, or if a kindly benefactor says, "Don't worry about it. You don't have to pay me back. Happy holidays."

Other Exceptions to Debt Discharge Rules

Insolvency

Debts can be excluded from your income for tax purposes if you're insolvent—the total amount of your debts exceeds the total fair market value of all your assets. This is the case even if you haven't yet filed for bankruptcy.

There's another catch: The extent of your insolvency must be as great as, or more than, the debt or debts that were canceled. For instance, you're fine if your debts exceed the fair market value of your assets by $10,000, and a lender forgives $10,000 in debt or less, but the difference becomes taxable income if your insolvency is only $10,000, and the lender cancels a $15,000 debt. You'd have to report that additional $5,000.

Student Debt

Generally, student debt canceled would be considered taxable income but there are certain exceptions. These include loan cancellation due to meeting certain work requirements, certain student loans canceled under the American Rescue Plan or debt discharged on account of a student loan forgiveness assistance program.

Mortgage Debt on Foreclosures

You don't have to count canceled debt as income, either, if it's associated with a foreclosure. The current exclusion is limited to $750,000 ($375,000 if you're married filing separately). The mortgage has to be on your principal residence to qualify.

The Bottom Line

Don't report a discharged debt until you've consulted with a tax professional about the exact details of your situation. You want to be very sure that you do, indeed, have to report the income. Likewise, plan on including a debt as income unless and until a tax professional tells you that you don't have to.

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