Bankruptcy Discharge: What are the tax consequences?

A very common question I discuss at initial bankruptcy consultations at my Asheville office is whether the IRS will treat discharged debts as income.  Simple answer:  No.  Allow me to explain why.

When someone negotiates a settlement with a credit card company, the forgiven portion of the debt is treated as income by the IRS.  So, if you have a credit card debt of $15,000, and the credit card company agrees to take $5,000 as full payment (and then charge it off as a bad debt on your credit report), you can expect $10,000 to be treated as income and pay taxes on it.  There are exceptions if you can prove an inability to pay at the time the debt was forgiven.  The IRS’ theory is that forgiving the debt is the same thing as the credit card company paying you the $10,000 in cash.

On the contrary, a debt discharged in bankruptcy is not a forgiven debt.  The credit card company has no choice when the Judge declares the debt discharged in bankruptcy.  Therefore, the discharged debts will not cost more money in taxes owed under IRS regulations.

Tax issues are complicated, and you should consult with a professional before taking action.  I would be happy to discuss your options during a free, initial consultation.

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