Bankruptcy Affects Your Taxable Income: Here's How
Richard Fonfrias, J.D.
Chicago's Financial Rescue & Bankruptcy Lawyer
Fonfrias Law Group, LLC
If you're under a lot of financial pressure, your lender may be willing to forgive all or part of your debt.
Yet, as good as this sounds, you need to know that this can dramatically affect your taxes.
This forgiveness of debt creates "cancellation of debt" income, called COD income, which, in most cases, adds to your IRS bill. At the time the lender forgives the debt, it is supposed to report the forgiven amount to you, the borrower, and to the IRS on a Cancellation of Debt Form 1099-C.
This Cancellation of Debt rule has several exceptions, including these:
Bankruptcy. When the cancellation of debt occurs, if you are in one of these forms of bankruptcy - Chapter 7 (liquidation), Chapter 11 (reorganization), or Chapter 13 (repayment plan) - then this income is entirely exempt from federal income tax.
Insolvency. If you are insolvent - meaning that the amount of your debts exceeds the fair market value of your assets - immediately before the lender forgives your debt, the COD income is exempt from federal income tax as long as it only reduces the amount of your negative balance. But if the COD income makes you solvent - meaning that you now have more assets than liabilities - then the COD income is taxable in the amount of your new positive balance.
Principal Residence Mortgage. If the lender forgave the debt on your home mortgage between 2007 and 2012, and if the debt cancellation met the government's requirements, then the amount of that forgiveness is exempt from taxation. This exemption does not apply to second mortgages, except under specific conditions. Nor does it apply to vacation home mortgages or rental property mortgages.
Deductible Interest. If some of the COD income was unpaid interest that was added to the principal amount of your loan - and then forgiven by the lender - the forgiven interest that was deductible is free from federal income taxation.
Seller Carryback Mortgage. If the COD income is from the seller (the previous owner) forgiving the mortgage debt, the COD income is exempt from taxes.
These and other exemptions are available to you under limited circumstances. So it's best to consult with a bankruptcy lawyer or CPA about whether these exemptions apply to you.