Tax Consequences in Bankruptcy

Many clients ask about the impact of filing bankruptcy when they file taxes the following year.  There is a common misconception that the discharged debts are treated as income and will result in a large tax owed to the IRS during the next tax season.  Fortunately, the IRS does not consider discharged debts as income.  Any debts that are discharged in your bankruptcy do not need to be reported on your future tax returns.

Keep in mind that there is a big distinction between debts that are discharged in bankruptcy and debts that are cancelled by a creditor.  If a creditor cancels or forgives a debt, this is treated as income by the IRS.  From the IRS viewpoint, the fact that you do not need to repay a debt or a portion of a debt is similar to the creditor giving you that money back.  You will receive a form called a 1099-C for any debts that are forgiven or cancelled and this needs to be reported in your tax return.

One of the major risks to trying to settle or negotiate with your creditors is that you will receive a form 1099-C if the creditor agrees to accept less than what you owe on a debt.  Many creditors or debt collectors will be willing to settle for significantly less than what you owe, sometimes as low as 50% or even less.  Make sure to keep this in mind if you are trying to find ways to deal with debts.  Paying $2,500 to settle a $5,000 credit card may sound attractive but it could end up costing you money in the long run if you ultimately owe income taxes on the other $2,500 that was forgiven.

If you have been struggling with debt, please call Hoglund, Chwialkowski & Mrozik for a free consultation.  Bankruptcy may be a good way to help you address your debt now and avoid creating more debt in the future in the form of tax liability.   Our experienced bankruptcy attorneys will discuss your options and let you know if bankruptcy is the best choice for you.  We would be happy to meet with you in one of our convenient locations in the Minneapolis-St. Paul area or in Rochester, Duluth, St. Cloud, or Mankato.

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