Thursday, February 20, 2014

Discharged Debt as Imputed Income?

I recently had a client contact me who had just gone through bankruptcy and received a discharge a few months earlier.  She reported that she'd received a 1099-C form from one of her larger creditors, and it looked like they were reporting the discharged debt as imputed income.  Her question was whether she needed to pay income tax on this cancelled debt.  The answer was no.

A limited class of creditors are permitted to send 1099-C forms to debtors who receive cancellation of their debt through bankruptcy, usually those that receive most of their most of their profit from the lending of money.  The debt cancellation has an obvious tax benefit to the creditor.  In this instance, the creditor was an "investment group" that "invested" in the purchase and collection of old debt.  However, regardless of whether the 1099-C issued by this particular creditor was proper or not, the amount of declared cancelled debt would not be imputed as income to the debtor.  Here's what the IRS has to say about debt discharged through bankruptcy:
Debt canceled in a title 11 bankruptcy case is not included in your income. A title 11 bankruptcy case is a case under title 11 of the United States Code (including all chapters in title 11 such as chapters 7, 11, and 13), but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
IRS Publication 4681, p. 5.  To declare the cancelled debt as being excluded from income by reason of bankruptcy, taxpayers must complete and file form 982 with their returns.

As an aside, even cancelled debt not obtained through bankruptcy may be excluded from income, if the taxpayer is "insolvent" prior to the debt being cancelled.  Insolvency is determine by a calculation of debt versus fair market value of your assets.  More information regarding this exclusion from income is given at the link provided above.

The bottom line is that, once a debt is discharged through bankruptcy, it is gone.  Even if the creditor wants to take a bite out of Uncle Sam to get some of it back, the debtor is off the hook.