How Does Bankruptcy Affect Your Taxes?

Bankruptcy can significantly alter a person’s tax obligations and reporting requirements. It introduces specific rules regarding which tax debts can be eliminated and how other financial changes, like debt cancellation, are treated for tax purposes. Understanding these interactions is important for individuals navigating the bankruptcy process.

Understanding Tax Debts in Bankruptcy

Certain tax debts may be discharged in bankruptcy, while others are not. Income taxes can be dischargeable if they meet specific timing criteria, known as the “3-2-240 rules.” For an income tax debt to be dischargeable, the tax return must have been due at least three years before the bankruptcy filing (including extensions), filed at least two years before the petition date, and assessed by the IRS at least 240 days prior to filing. These conditions apply to federal and sometimes state income taxes, but other tax types often have different rules.

Priority tax debts are generally non-dischargeable. These include recent income taxes that do not meet the 3-2-240 rules. Trust fund taxes, such as payroll taxes withheld from employees’ wages, are also typically non-dischargeable because they are considered funds held in trust for the government. Taxes related to fraudulent returns or those where there was a willful attempt to evade taxes are never dischargeable.

Property taxes have specific dischargeability rules. Property taxes incurred before the bankruptcy filing may be dischargeable if they were last payable without penalty more than one year before the bankruptcy petition was filed. However, even if the underlying property tax debt is discharged, any existing tax lien on the property typically survives bankruptcy.

The dischargeability rules can also vary between Chapter 7 (liquidation) and Chapter 13 (reorganization) bankruptcy. In a Chapter 7 case, if the tax debt meets the dischargeability criteria, the personal liability for that debt is eliminated. In Chapter 13, non-dischargeable priority tax debts must generally be paid in full through the repayment plan over three to five years. For income tax debts that are dischargeable, they are treated as general unsecured claims in a Chapter 13 plan, similar to other unsecured debts like credit cards.

Tax Consequences of Discharged Debt

When a debt is canceled or forgiven outside of bankruptcy, the canceled amount generally becomes taxable income to the debtor, known as Cancellation of Debt (COD) income. This is defined by IRC Section 61. For example, if a creditor forgives $5,000 of a $10,000 debt, that $5,000 could be considered taxable income. Creditors often issue Form 1099-C, Cancellation of Debt, to report these amounts to both the debtor and the IRS.

However, IRC Section 108 provides an exclusion for debt discharged in a Title 11 bankruptcy case. This allows individuals to exclude COD income from gross income if the discharge occurs as part of a bankruptcy proceeding. Thus, debt forgiven through bankruptcy typically does not result in a tax liability for the debtor. This exclusion applies to various types of debt, including credit card debt, personal loans, and mortgages, when discharged in bankruptcy.

IRC Section 108 also provides an insolvency exception, allowing exclusion of COD income if the taxpayer is insolvent immediately before the debt discharge. Insolvency means that a taxpayer’s total liabilities exceed the fair market value of their assets.

While the insolvency exception can also prevent COD income from being taxed, the bankruptcy exclusion takes precedence if both apply. The bankruptcy exclusion is broader, as it does not require calculating the extent of insolvency.

Adjusting Tax Attributes

While the exclusion of Cancellation of Debt (COD) income in a Title 11 bankruptcy case prevents immediate taxation, it often requires reducing certain tax attributes. This attribute reduction, mandated by IRC Section 108, prevents a double benefit. The reduction effectively defers the tax consequences of the excluded income.

Common tax attributes that may be reduced include Net Operating Losses (NOLs), which are valuable for offsetting future taxable income. Other attributes subject to reduction include general business credits, minimum tax credits, capital loss carryovers, and foreign tax credit carryovers. The basis of property held by the taxpayer may also be reduced.

There is a specific order in which these attributes must be reduced, outlined in IRS regulations. The reduction of tax attributes is typically reported on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). This form is filed with the taxpayer’s income tax return in the year the debt is discharged. This ensures the economic benefit of the discharged debt is eventually accounted for in the tax system.

Filing Taxes During and After Bankruptcy

Individuals filing for bankruptcy have specific tax filing obligations both before and during the bankruptcy proceedings. All necessary tax returns for periods prior to the bankruptcy filing must be filed. Failure to do so can lead to complications, including potential dismissal of the bankruptcy case.

In Chapter 7 and some Chapter 11 bankruptcy cases, a separate legal entity, known as a “bankruptcy estate,” is created for tax purposes. This estate may be required to file its own income tax return, Form 1041, U.S. Income Tax Return for Estates and Trusts, if it generates sufficient gross income. The debtor’s income, deductions, and credits typically transfer to this estate at the time of the bankruptcy filing.

An individual debtor in a Chapter 7 or Chapter 11 case may elect under IRC Section 1398 to split their tax year into two short tax years. The first short tax year ends on the day before the bankruptcy filing date, and the second begins on the filing date and ends on December 31. This election can be beneficial if there is a significant tax liability for the pre-bankruptcy portion of the year, as it allows that liability to become a claim against the bankruptcy estate. To make this election, the debtor must file a return for the first short tax year by its due date, noting “Section 1398 Election” at the top of the return.

When debt is discharged in bankruptcy, taxpayers must report this exclusion and any corresponding attribute reductions on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). This form is attached to the individual’s or the bankruptcy estate’s tax return for the year the debt was discharged. This form informs the IRS that excluded COD income is not taxable and details attribute adjustments. Regular tax filing obligations, including paying new taxes as they come due, continue after the bankruptcy filing.