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Tax Liabilities and Implications with Filing Bankruptcy

Filing bankruptcy often involves tax implications, but not in the ways you might think.  Filing bankruptcy itself is not a taxable event.  However, there could be tax implications if property is sold to pay creditors, or if debts are forgiven by creditors.

Typically, when you owe someone $600 or more and they cancel or forgive your debt, the amount canceled becomes taxable income under Internal Revenue Service (IRS) rules. There are exceptions to these rules, which include:

  • Canceled student loans when the student works for certain employers
  • Debt cancellation that would have been a deduction if paid
  • Debt reduction granted by a seller if property purchase created the debt
  • Insolvency

In addition, when you file for bankruptcy, all your non-exempt assets become part of the bankruptcy estate. The IRS treats the bankruptcy estate as a separate taxable entity when a person files for Chapter 7 bankruptcy. In Chapter 7, the trustee sells non-exempt assets to pay creditors and the bankruptcy estate would be charged with paying any income tax obligations arising from the sale of the assets.

The fact is there are many tax factors to consider when filing bankruptcy. The IRS devotes an entire publication called the Bankruptcy Tax Guide to explain how taxes and bankruptcy work.

Canceled debt

In terms of canceled debt, when bankruptcy discharges debt, the IRS does not consider it taxable income because bankruptcy is considered an insolvency proceeding. That is the up-side. The down-side is that the canceled debt could reduce other tax benefits.

Tax benefits that may be reduced as a result of canceling debts include:

  • Net operating basis
  • General business carry overs
  • Capital losses
  • Basis of debtor's property
  • Foreign tax credit
  • Minimum tax credit

It is always a good idea to file your tax returns.  If you are considering filing a chapter 13 bankruptcy, it is not just a good idea, but a requirement.  You must produce a copy of your federal, state, and local (if any) tax returns after filing your bankruptcy petition. Failing to file can result in your bankruptcy being converted to another chapter or dismissed, meaning you won’t get the relief you expected.

The best way to deal with tax complexity is to work with an experienced bankruptcy lawyer and carefully follow the legal advice.

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