Forgiven Debt, Taxable Income and Bankruptcy
Creditors can 'write off' debts; forgive them altogether. Great, for you, right? Well, not necessarily.
All of a sudden, you receive an IRS 1099 form, showing that your debt in the sum of (>>fill in your amount) was forgiven and can now be considered taxable income by Uncle Sam.
Such a scenario is very common in the case of junior mortgage holders who lose their lien on a property after the first mortgage holder forecloses.
However, there is still hope in bankruptcy. Internal Revenue Code section 108 explicitly states that debts discharged in a bankruptcy case do NOT get included in income on the debtor taxpayer’s tax return.
The clincher: Timing. The Internal Revenue Code also states that such a discharge must take place before the event giving rise to the debt obligation. This you would have to figure out with a tax professional, but there is hope, just make sure that you file your bankruptcy IN TIME.
There may be some exceptions carved out of the Tax Code if this scenario involves your home, but no such protections exist for other real property.
Tread carefully, take care of business in a timely fashion, and you may escape having to pay a bunch of extra tax on forgiven debt, an amount that could be sizeable if you are looking at a forgiven mortgage debt.