When creditors tell debtors they don't have to repay the money owed, the IRS usually requires debtors to pay taxes on the cancelled amounts. It's natural for people filing bankruptcy to wonder if the same applies to debts discharged by the bankruptcy court. Here's what you need to know about this issue to help you plan accordingly.

Discharged Debts Are Non-Taxable

The IRS considers cancelled debt to be income since the removal of the obligation to repay the money is essentially the same as the creditor sending you a check in the mail. Thus, failure to account for this money on your tax returns can lead to the same type of legal consequences as if you'd failed to report all of the income you earned from a job or a business.

The only exception to this reporting requirement is if your debts are discharged via bankruptcy because this process wipes out any and all the debtor's obligations towards the debt, including any tax consequences. Thus, once your case concludes, you can file your taxes normally without having to worry about reporting the debts you included on your bankruptcy schedules.

It should be noted, though, that any tax attributes and benefits you may have been entitled to regarding your debt will be passed on to your bankruptcy estate and used by the trustee to manage your case. For instance, if you were entitled to any tax write-offs because of a side business you owned, the bankruptcy trustee would claim those write-offs in your case to reduce the amount of debt owed to creditors. You would not be able to use those when you filed your taxes and could get in trouble if you tried. Thus, it's essential you consult with a bankruptcy attorney or tax professional about how to handle this issue if you expect you are entitled to tax write-offs.

Dealing With the IRS

Although you may not be required to pay taxes on debt cancelled via bankruptcy, sometimes there's a miscommunication and you'll receive a 1099-C form from the IRS notifying you of your obligation to pay. However, there's nothing to panic over.

If you do receive this notice from the IRS and you're absolutely certain the debt has been discharged through bankruptcy, you simply need to file the IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness when you submit your taxes for the next year. This notifies the IRS that the debt in question is exempt from taxation and the agency will update its records accordingly.

For more information about chapter 7 bankruptcy filing services or for assistance with your case, contact an attorney.