I have focused on some of the tax issues surrounding Chapter 7 and Chapter 13 bankruptcy this week as the deadline nears for Americans to file their federal income taxes. I wanted to end the week by discussing the difference between discharged debt and canceled or forgiven debt. This significant distinction can cause tremendous problems for many families when not properly planned.
Debt discharged in a bankruptcy case is not taxable income, but debt that has been canceled or forgiven can still become a tax liability. Debt is canceled or forgiven when the creditor stops its collection efforts and reports it to the Internal Revenue Service (IRS) as lost income. This reduces the tax burden for the creditor, but the IRS states that if a debt you owe is canceled or forgiven, you must include the canceled amount in your income. While a few hundred dollars may not make much of a difference to your income, having to include several thousand dollars in forgiven or canceled credit card debt could have a hugely detrimental impact for many families.
Again, you cannot be taxed on debt that is discharged in bankruptcy. This difference illustrates why it is in your best interest to work with a Maryland or Washington DC bankruptcy attorney who can sort through the complications and work to get as much of your debt discharged as possible. While an individual filing Chapter 7 or Chapter 13 bankruptcy could still be liable for taxes on forgiven or canceled debts, your lawyer can help you identify the exemptions you need to avoid receiving a tax bill or—even worse—audit notice.