"Due to job loss and a debilitating injury my wife and I filed for Bankruptcy on our unsecured debts. None of our creditors challenged this action and the DLD was in March, 2006. I have since been told that this debt must be listed as income with the IRS for 2006. I was under the impression that these are 'forgiven debts' and as such are not taxable as income. Can you clear this up for me? Are there any forms or schedules that we need to obtain and submit?"Debts discharged in a bankruptcy proceeding usually are not taxable income to the petitioner. This differs from the usual treatment for canceled debts.
Debts Canceled inside a Bankruptcy Proceeding
"Taxpayers who filed bankruptcy are generally not required to include cancelled debt in taxable income," explains Cindy Hockenberry, enrolled agent and tax information analyst with the National Association of Tax Professionals. Canceled debts are also excluded from income if the taxpayer is insolvent or if the cancellation is intended as a gift to the borrower.
Hockenberry advises taxpayers with discharged debt to attach "Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), ... to the taxpayer’s income tax return to show the IRS that the discharged amount is excluded from income under Code Sec. 108."
Debts Canceled (but not through Bankruptcy)
"Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. You have no income from the canceled debt if it is intended as a gift to you. A debt includes any indebtedness for which you are liable or which attaches to property you hold," explains the IRS in Publication 525.
The IRS goes on to explain how to report the canceled debts on your tax return: "If the debt is a nonbusiness debt, report the canceled amount on Form 1040, line 21. If it is a business debt, report the amount on Schedule C or Schedule C-EZ (Form 1040) (or on Schedule F (Form 1040), Profit or Loss From Farming, if the debt is farm debt and you are a farmer)."