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Cancelled or Forgiven Debt Can Lead to Higher Tax Bill—Unless You File Bankruptcy

On Behalf of | Jun 20, 2014 | Bankruptcy |

When people first get the news from their creditors or mortgage companies that their debt has been forgiven, they are thrilled—that is, until they get the tax bill. Under the tax laws, any amount of debt that is forgiven can be taxed as income. So, that $10,000.00 that your credit card company just forgave: that is considered $10,000.00 of additional income on which you must pay income tax. The far more dangerous scenario is where your mortgage debt was partially forgiven in a short sale or where a second mortgage is entirely forgiven. The increased tax liability in those cases can be much larger, tax bills upwards of $30,000.00 are not uncommon when a mortgage debt is forgiven.

Up until December 2013, homeowners were partially protected by the Mortgage Forgiveness Debt Relief Act. Under the Act, homeowners were given a tax break for forgiven mortgage debt on their primary residence, but this tax break has expired and may not be renewed.

However, there is still relief available—bankruptcy can discharge both the debt and allow you to avoid tax liability on the forgiven debt. When a debt is discharged in bankruptcy, it has not been “forgiven,” rather your personal obligation to repay the debt has been legally discharged under the Bankruptcy Code.

According to the IRS:

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 (2013).

To add to the unfairness of this all, while homeowners are stuck with a larger tax bill from forgiven debt, the mortgage companies and other creditors get to take the forgiven debt as a tax write off, and lower their tax bills.

If you are facing potential tax problems due to a forgiven debt, please call our office for a bankruptcy consultation today. For more information on bankruptcy, please visit our site, Fred Nix is an associate and Laura Margulies is the president of the law firm of Laura Margulies & Associates, LLC, which has offices in Rockville, Greenbelt and Hagerstown.