Ahh forgiveness. What a lovely word. It’s at the foundation of most religions and psychologists tell us it’s good to lower stress. Bankruptcy has its own forgiveness: Forgiveness of debts, or at least the obligation to pay on the debts (see my Letter “D” post on Discharge of Debts).
Forgiveness of Debt Can Become Taxable Income
But forgiveness of debt can also be taxable income. That’s right! If, for example, your home is foreclosed on and there isn’t enough from the sale to pay all the junior mortgages, then those mortgagees have a couple of options (in California, anyway): 1. Pursue you for the deficiency amount owed; or 2. Issue a 1099 for forgiveness of debt.
If they choose number 2, you will have to include the amount of their deficiency (loss) as income on your tax return! More recently some banks are simply forgiving “under water” junior mortgages even without it being requested which can also be a taxable even if you are not insolvent at the time of the forgiveness.
Bankruptcy Prevents Forgiven Debt From Becoming Income
But wait, there’s hope. Internal Revenue Code section 108 explicitly states that debts which are discharged in a bankruptcy case do NOT get included in income on the debtor taxpayer’s tax return. Thus, by timely filing a bankruptcy case, not only can one get rid of the underlying debt obligation, but they can also prevent it from becoming taxable income to them! By timely I mean that in most instances the bankruptcy case usually (but not always) needs to be filed before the event takes place that would otherwise give rise to the tax obligation. This requires a consult with a qualified tax professional to ensure the correct timing.
(Note: the Internal Revenue Code also states that although the debt “forgiven” in a bankruptcy case is not taxable income, it can be used to decrease any tax attributes the taxpayer has, such as loss carryforwards, etc. It is important to discuss your specific situation with both a qualified CPA and bankruptcy attorney)
This article is part of my bankruptcy alphabet series
Image Courtesy of Sprungli