Under the Internal Revenue Code, the general rule is that the discharge of a debt is a form of gross income. The forgiveness of a debt does sound nice, but it does come with some consequences.
For example, if a creditor forgives a debt of $20,000, you would have an additional $20,000 for taxable income. At a conservative tax rate of 15% you would owe an additional $3,000 in federal income taxes for that year.
Unlike the debts that are discharged in a chapter 7 or chapter 13 bankruptcy, debts forgiven by creditors are subject to tax liabilities. Taxes, like other unsecured debt, can be discharged in a bankruptcy. But there are additional rules for tax liabilities.
Section 507(a)(8) of the bankruptcy code provides that tax debts are excepted from discharge if the required filing date for the tax return was within three years before the bankruptcy petition was filed or the taxes were assessed within 240 days before the bankruptcy petition was filed. (Also note: Tax debt may not be dischargeable according to section 523(a)(1)(C) with respect to which the debtor made fraudulent returns or willfully attempted in any matter to evade or defeat such tax.)
In the case of a forgiven debt, and the taxes owed on the forgiven debt, the same rules apply. This debt will not be discharged if the tax debt was within the three years prior to the bankruptcy filing or assessed within 240 days before the bankruptcy filing. Creditors who forgive you a debt will provide you with a tax form. This form is filed with your taxes to let the taxing authority know of the debt forgiveness and subsequent increase in gross income and the tax liability associated with it.
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Although, negotiating settlements with your creditors can bring you relief from your debts, there are hidden consequences. Speak with your attorney about the possible consequences of forgiven debt and the potential tax implications. Contact the attorneys at LifeBackLaw and see us at www.LifeBackLaw.com.