Bankruptcy Tax Deductions

There are no formal tax deductions for filing bankruptcy. However, there is one significant tax advantage in that when you enter into bankruptcy all discharged debt is not recognized as revenue. Generally, when debt is forgiven, the amount is recognized as taxable revenue. As bankruptcy procedures generally involve a lot of debt being wiped out, this represents a significant benefit in that year. However, in exchange for this benefit, future tax benefits are decreased.

Common Types of Bankruptcy for Individuals

There are two types of bankruptcy options for individuals. The first is Chapter 13, or individual debt adjustment. Under this option, individuals with a regular income are allowed to restructure their debt and propose a plan that would allow them to pay off some or all of their debts over three to five years. This plan allows the individual to keep her property so long as she keeps to the plan. The second type is Chapter 7 or liquidation. This is the more drastic option, where most of the individual’s property is placed into a separate estate and is used to pay of his debts. In both cases, some of the individual’s debts are forgiven while the rest are paid off. At the end of the process, the individual can start over without debt.

Excluding Forgiven Debt for Taxes

While forgiven debts are generally included in taxable income, all debts forgiven through bankruptcy are not. The reason this forgiven debt is excluded is because the Internal Revenue Service recognizes the reality of the situation. It will not waste time and effort trying to recover tax revenue from people who cannot pay it in the current year.

Decrease in Future Tax Benefits

Since the IRS will not include forgiven debt in taxable income in a current year, it will try to recover this lost revenue by increasing the taxpayer’s future taxable income. It will do this by decreasing future deductions and credits. Generally, individuals will be allowed to “carry forward” past losses and credits to offset future income, which would lower their tax liability. In a bankruptcy with forgiven debt, those tax benefits are decreased by the amount of the forgiven debt not included in taxable income. If the amount of forgiven debt exceeds those credits and losses, the basis of taxable assets are decreased by the remaining amount. The effect of this decrease is that when these assets are sold, more of the proceeds are taxable. By doing this, the IRS ensures that the amount of forgiven debt that was not taxable in the current year will be taxable in the future.

Tax Tips

For complex returns and especially for bankruptcies, it is a good idea to consult with a certified public accountant (CPA) or licensed attorney, as they can best address your individual needs. Be sure to keep your tax records for at least seven years to protect against the possibility of future audits. Every effort has been made to ensure this article’s accuracy, but it is not intended to be legal advice.