Bankruptcy or Debt Forgiveness: Income Tax Liability Compared

If you are considering filing bankruptcy or considering either a short sale of your home, or perhaps going through a debt management program, you need to take into account the income tax consequences of each alternative. 

Filing bankruptcy provides not just a way for you to erase your debts, but also gives you a way to avoid any liability for income tax when the debts are wiped out.  Section 108 of the IRS Code specifically excludes debts discharged in bankruptcy from being considered income, which means that no income tax is owed on the debts that are discharged through bankruptcy.     

Forgiveness of  debt by going through a debt management program or by completing a short sale of your home  is considered taxable income.  (You should also  keep in mind that getting your mortgage company to forgive all or a portion of your mortgage balance still owing from a short sale is, in many cases, next to impossible.)  This means that you will owe income tax on the amount of the debt that is forgiven by your creditors.  If, for example, you sell your home for $ 100,000, but owe your mortgage company $ 150,000, and your mortgage company were to forgive the remaining debt of $ 50,000, your mortgage company would report to the IRS (by issuing a Form 1099) that you just received income of $ 50,000.   Although some portion of any mortgage deficiency that might be forgiven could be exempt from income tax (see recent article on explaining this in detail [click here]), you would be required to prove to the IRS, with documentation, that you do not owe any portion of the amount reported to the IRS on that Form 1099.  The burden is on you to establish that all or a portion of the $ 50,000 is not taxable.  You should strongly consider whether it is worth all the stress and effort to convince the IRS that the forgiveness of all or a portion of that debt was not taxable.   To qualify for any relief, the short sale must meet certain specific requirements (for one, the property must be your principal residence).  For an excellent discussion of myths about mortgage debt forgiveness resulting from a short sale being exempt from taxation, [click here].

The best way to determine whether it would be wise for you to file bankruptcy or to consider any alternatives that can provide you true relief from your debts is to meet with a bankruptcy attorney.  Call me today at (937) 293-2392, for a free consultation.  I will help you determine what is your best plan to eliminate your debts.

Jerry A. Meadows, Attorney at Law

jerry-headshotI want to share with you my experience in bankruptcy and other areas of the law, my training, and my education. My experience can be of great benefit to you in helping you deal with your financial difficulties.

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