Can I Claim Bankruptcies on My Taxes?

Bankruptcy proceedings offer debt relief and have specific tax implications. Understanding these implications requires awareness of how federal income tax rules intersect with bankruptcy law. This article focuses on how bankruptcy impacts your tax situation.

Tax Treatment of Debt Discharged in Bankruptcy

When a debt is canceled or discharged for less than the amount owed, the canceled amount is considered taxable income. The Internal Revenue Service (IRS) requires reporting this. Creditors often issue Form 1099-C, “Cancellation of Debt,” to both the debtor and the IRS when a debt of $600 or more is canceled.

An exception exists for debt discharged in a Title 11 bankruptcy case, which includes Chapter 7 and Chapter 11 bankruptcies. Debt canceled as part of a bankruptcy proceeding is not considered taxable income to the debtor. Even if you receive a Form 1099-C for a debt discharged in bankruptcy, you do not need to include this amount in your gross income.

To claim this exclusion, debtors must file Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness,” with their federal income tax return for the year the debt cancellation occurs. Failure to file Form 982 can lead to an income tax deficiency notice from the IRS, which might assume the canceled debt is taxable.

Creditors are required to send Form 1099-C even if the debt was discharged in bankruptcy. The exclusion under Title 11 of the U.S. Bankruptcy Code ensures that such debt does not count as income for federal tax purposes.

Adjustments to Tax Attributes

While debt discharged in bankruptcy is generally not taxable income, the amount of excluded discharged debt must be used to reduce certain “tax attributes” of the taxpayer. Tax attributes are specific tax benefits that can reduce future tax liabilities. This reduction ensures a balance, preventing a double benefit where the taxpayer avoids tax on the discharged debt and retains full use of associated tax benefits.

Examples of tax attributes include Net Operating Losses (NOLs), general business credits, capital loss carryovers, the basis of property, passive activity loss and credit carryovers, and foreign tax credit carryovers. These attributes must be reduced in a specific order outlined by tax law. The first attribute to be reduced is Net Operating Losses, followed by general business credits, then the minimum tax credit, capital loss carryovers, and then the basis of the taxpayer’s property.

The reduction of credit carryovers occurs at a rate of 33 1/3 cents for every dollar of excluded debt, while other attributes are reduced on a dollar-for-dollar basis. This attribute reduction process is reported on Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness.” The purpose of Form 982 is to report the excluded amount and the corresponding reduction of these tax attributes.

This reduction happens after the tax year in which the debt discharge occurs. A taxpayer may elect to first reduce the basis of depreciable property before reducing other tax attributes, which can be advantageous in certain situations. For instance, if a debtor has $50,000 in canceled debt and a $10,000 NOL, the NOL would be eliminated, and the remaining $40,000 would be applied to the next attribute in the statutory order.

Tax Filing Obligations for the Bankruptcy Estate

For individuals filing under Chapter 7 (liquidation) or Chapter 11 (reorganization) bankruptcy, a separate taxable entity known as the “bankruptcy estate” is created. This estate is distinct from the individual debtor for tax purposes. The bankruptcy estate comprises property that belonged to the debtor before the bankruptcy filing date.

The bankruptcy estate is responsible for its own tax filings, including reporting income generated and expenses incurred by the estate. The trustee appointed in a Chapter 7 case, or the debtor-in-possession in a Chapter 11 case, manages the estate’s finances and is responsible for filing its tax returns. If the bankruptcy estate generates gross income that meets or exceeds the minimum filing threshold, which for 2024 is $14,600, the trustee or debtor-in-possession must file Form 1041, “U.S. Income Tax Return for Estates and Trusts.” An Employer Identification Number (EIN) must be obtained for the bankruptcy estate for these filings.

The individual debtor continues to file their own individual income tax return (Form 1040 or 1040-SR) for income earned outside the bankruptcy estate. Income, deductions, and credits belonging to the bankruptcy estate should not be included on the debtor’s personal return. In Chapter 11 cases, if the debtor remains in control as a “debtor-in-possession,” they may need to file both their individual return and the estate’s Form 1041.

Individuals filing under Chapter 13 bankruptcy do not create a separate taxable bankruptcy estate. In these cases, the individual debtor continues to file their own Form 1040, reporting all income and deductions. The debtor’s tax year might be affected by the bankruptcy filing; in Chapter 7 or 11 cases, the debtor can elect to close their tax year on the day before filing the bankruptcy case, creating two short tax years. This election can make the tax liability for the first short tax year an allowable claim against the bankruptcy estate.