Tax Effect of Debt Cancelation in a Bankruptcy

Generally, the cancelation of debt that you owe is considered income for federal income tax purposes. But there are some exceptions. The Mortgage Forgiveness Debt Relief Act of 2007 allows you to exclude the discharge of debt on your principal residence as a result of a foreclosure or mortgage restructuring. Other exceptions include certain farm debt, non-recourse loans, debts that are discharged through bankruptcy or in case of insolvency.

When a debt is canceled under a bankruptcy proceeding, the amount canceled is not considered taxable income. But the canceled debt reduces other tax benefits to which you may otherwise be entitled. By reducing these tax benefits, called tax attributes, the tax on the canceled debt is postponed but not entirely forgiven.

There is a certain order in which tax attributes are decreased by the amount of the canceled debt. First, if you have a net operating loss in the year your debt was canceled through the bankruptcy proceedings, that loss and any net operating loss carryovers you may have would be reduced. Then any general business tax credits you have would be reduced, including carryovers.

The next tax attribute to reduce is any minimum tax credit available at the beginning of the tax year following the year your debt was canceled. Then you would reduce any net capital losses or net loss carryovers. After that the basis of any depreciable and non-depreciable property you have is reduced. Next any passive activity loss and credit carryovers to the year of the debt cancelation would be reduced. And finally, if you have any foreign tax credit carryover, that amount would be reduced.

As the debtor, you could choose to first reduce the basis of any depreciable property you own by all or part of the canceled debt. By reducing the basis of the property, you would be increasing the potential taxable gain you have if you sell or dispose of the property in the future.

According to the IRS, tax attributes are reduced dollar for dollar by the amount of canceled debt, except for credit carryovers, which are reduced 33 1/3 cents per each dollar of canceled debt. As explained on Lawyers.com, if you file for chapter 7 bankruptcy, a separate bankruptcy estate is set up and the reduction of tax attributes would be done by the trustee on the bankruptcy estate's tax return. If you file under chapter 13, the reductions would be made on your personal tax return since a separate bankruptcy estate is not created.

When your debt is discharged in a bankruptcy, Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) must be filed to indicate the reason for the discharge of debt and how the canceled debt will be applied to reduce your tax attributes.

Sources:

Bankruptcy and Tax Consequences, Lawyers.com

Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), IRS

Home Foreclosure and Debt Cancellation, IRS

Publication 908, Bankruptcy Guide, IRS

Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments, IRS