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Bankruptcy Exception to Paying Income Taxes on Cancelled or Forgiven Debt

Published March 26, 2014 by Sasser Law Firm

When it comes to overwhelming debt, there are options to consider and bankruptcy is just one of those choices. A consultation with a bankruptcy lawyer should not feel like asking a barber whether or not you need a haircut. Depending on the type of debt owed, sometimes negotiations with the lender can lower your obligation to a level manageable enough that you can climb out of the mire on your own without declaring bankruptcy. A settlement of an outstanding debt or a balance that is forgiven after a specific period of repayment may be considered cancelled or forgiven debt and it feels pretty good in the moment. There are trade offs and the cost of a forgiven or cancelled debt might be a higher tax liability. That’s right: the tax code considers forgiven debt “income.” The cancelled debt might not be such a windfall when the additional taxes are factored into the equation. Forgiveness of a student loan balance after 10-25 years of repayment or the cancellation of the remaining balance of a mortgage after a short sale or foreclosure are just a few of the type of debts that might wind up as taxable income if not qualified under a special provision in the tax code for exemption from taxable income. Under the tax code when a debt is discharged during a bankruptcy case, it does NOT count as taxable income. In this instance, bankruptcy may be a more powerful tool than non-bankruptcy debt relief options. A bankruptcy discharge does not erase the debt itself; it merely eradicates the obligation to pay the debt. The tax code specially excludes debts discharged in bankruptcy from taxable income. In addition to the bankruptcy exception, there is also an exception if the taxpayer is insolvent. For more information you may want to look at IRS form 982 and/or consult with a qualified tax professional. Considering the tax implications of various debt relief options is important. Contact Sasser Law Firm for a free consultation if you need help examining your options.

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