Bankruptcy Blog Reader's Question: When A Debt Is Forgiven, Don't You Have To Pay Tax On That?

One reader of my Indiana bankruptcy blogs raised an interesting question. She had heard that, whenever a debt is forgiven, you have to report that on your taxes as if you had earned the money. So, she is asking, is that also true when a bankruptcy court discharges a debt?

The answer, I'm happy to report, is "No". Cindy Hockenberry of the National Association of Tax Professionals explains that taxpayers who file bankruptcy are not required to include cancelled debt in their taxable income. Hockenberry advises taxpayers to attach Form 982 to their income tax return to show the IRS that the discharged amount is excluded from income under IRS Code Section 108.

By way of background, when there's no bankruptcy filing, if a debt you owe is cancelled or forgiven (unless that's a gift), you DO need to include the cancelled amount in your income. If it's a personal debt that was cancelled, you normally put that on your Form 1040, line 21. If it's a business debt, it goes on Schedule C of your return. Since I do not offer tax advice, it's best to consult a tax adviser, who can tell you the best way to handle your individual situation.

When it comes to bankruptcy, the law requires that debtors must file all tax returns that become due after the bankruptcy filing. If that does not happen, the taxing authority (IRS, state, or local) can request that the bankruptcy case be dismissed by the court.