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Tax Obligation for Debts Discharged in Bankruptcy

Many people who file for personal bankruptcy wonder about their tax obligation for debts discharged in bankruptcy. And taxes are an important matter to consider: if a person files bankruptcy because they can't afford to pay their debts, are they expected to pay the IRS?

The good news is that most debts discharged in bankruptcy are not considered taxable income. This is just one benefit bankruptcy has over debt settlement, where debts forgiven by creditors are seen as a "gift" and considered a source of income. Here’s a closer look at the ways bankruptcy and taxes are related.

What Is My Tax Obligation for Debts Discharged in Bankruptcy?

In some situations, cancelled debts (that is, debts that a lender agrees the borrower has no obligation to pay) are considered taxable income. That's because the person borrowed money with the intent of paying it back; any amount that the borrower is no longer required to repay is essentially income the borrower spent.

Anything from negotiating with creditors to walking away from a mortgage could result in "income" in the eyes of the IRS.

But there are several exceptions to the taxable income rules. These include:

  • Debts discharged in bankruptcy: The Bankruptcy Code is explicit in stating that debts excused through bankruptcy cannot be considered part of a filer's taxable income.
  • Insolvency: This is a situation where a person's total debts are greater than the fair market value of her total assets. Those who can prove that they meet the legal definition of insolvency are not required to count canceled debts in their taxable income. Proving insolvency, though, can be tricky; anyone interested in learning more should contact a lawyer or a tax professional.
  • Some farm debts: Those who earn more than half of their incomes by operating farms or meet other qualifications do not have to consider certain canceled farm debts as part of their taxable income.
  • Non-recourse loans: These are loans for which a lender's only possible recourse for non-payment is to repossess property connected to the loan. In certain situations, canceled debt from these loans cannot be counted as part of a person's taxable income.

Learn More about Your Tax Obligation for Debts Discharged in Bankruptcy

If you're interested in learning more about seeking debt relief through bankruptcy, you can take this opportunity to connect with a bankruptcy lawyer practicing in your area for a free, no-obligation consultation.

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