Does Bankruptcy Affect Your Taxes?

The content of this post is not intended to replace the advice of a licensed tax professional. Consult a qualified professional for questions specific to your individual circumstances.

If you were among the 530,000 families that turned to bankruptcy last year, you may be concerned about the potential tax implications of bankruptcy. You’ll be relieved to discover that in most cases, there will be no tax implications.

Bankruptcy Basics

In a chapter 7 bankruptcy, you are protected from any and all debt collection activities. All of your debt (with the current exception of student loan debt) is liquidated. In essence, your debts are cancelled.

While this may give you the badly needed breathing room in terms of your budget, a bankruptcy notation will remain on your credit report for up to 10 years.

A chapter 13 bankruptcy is for individuals who are in financial distress, but who are not eligible for a full liquidation under Chapter 7.

The Chapter 13 bankruptcy, also known as the “wage earner’s plan” allows those with regular income to pay off their debt according to a mutually-agreed upon repayment plan, paying off debt in 3 to 5 years.

You will be allowed to keep your home while tending to unsecured debts. Chapter 13 is ideal for those who have the means to pay off creditors, but who are unable to do so under the creditor’s original timeframe.

Additional information regarding Chapter 13 bankruptcy can be found here.

Tax Implications

A canceled debt is one that is forgiven or discharged. You no longer owe the money to the creditor. The creditor can no longer initiate or continue collection activities.

While taxpayers are required to report all income, you are not required to report forgiven debts as income. This rule applies even if the creditor issues a 1099C, “Cancellation of Debt” form.

If you do receive this form from them and from your other creditors included in your bankruptcy petition, be sure to attach Form 982 to your return. Doing so will alert the IRS that the “income” is not taxable.

If you fail to do so, the IRS may flag your return for further investigation (audit), since the creditors also send a 1099C to the IRS, reporting the forgiven debts as income.

What If You Do Have To Report Discharged Debts As Income?

In some instances, you will have to report discharged debts as income. Enter the total amount in the “other income” field on your 1040 form. Your bankruptcy attorney or tax pro can advise you if this rule will apply to your case.

Bankruptcy in any form is a last resort for households who are in dire financial distress. Up to 66.5% of all bankruptcies filed last year were due to medical expenses. Lost income from an illness was another key reason for bankruptcy.

Other circumstances include job loss, death of a spouse, and divorce.

While bankruptcy is not for everyone, it may be the only option for those in financial crisis. Always consult with a bankruptcy attorney prior to filing.

As with any major financial decision, always consult a licensed professional. They will assist you in formulating a solid plan for moving forward. A licensed professional can also help you weigh the available options in the wake of a financial crisis.