You may have heard that IRS considers canceled, forgiven or discharged debts to be income and you must disclose this revenue on your tax return. Whether the obligation was canceled, discharged, or forgiven, it must be reported as income to the IRS. That's accurate, at least to some degree, but this isn't a general rule that applies to all discharged debts.

If a taxpayer files for bankruptcy, they are often exempt from the requirement that the canceled obligations be included in the taxpayer's taxable income. Even if you get a Form 1099-C from a lender detailing the amount of the debt that has been canceled or discharged, this will not change the fact that this is the situation. Your income tax return should include an attached Form 982. This demonstrates to the IRS that the sum discharged is not considered income according to Section 108 of the Code.

Be careful to affix the form since the lending institution must send a copy to the Internal Revenue Service (IRS). If you don't include the amount on your tax return and you don't provide any explanation or data to back up your decision, this might raise a red flag.

Debts Discharged Before Bankruptcy

If the lender discharged your obligation and sent Form 1099-C to the Internal Revenue Service before you filed for bankruptcy, you must disclose the amount of the forgiven debt on your tax return. When this occurs, there is no longer a debt to be paid. You are no longer required to repay the borrowed money since it is now considered income.

Canceled Debts That Are Gifts

Publication 525 of the Internal Revenue Service explains that if a canceled debt comes to you as a gift or a bequest, you are exempt from the requirement that you include it in your income. If a kind family member or friend forgives money you owe them in their will or a generous donor says, "Don't worry about it," the debts in question are not considered income and should not be reported as such. You are not required to make restitution to me.

Other Exceptions

If you are insolvent, which means that the whole amount of obligations is more than total fair market values of all of your assets, you may be able to remove debts from your income when filing your taxes. Even if you haven't started the bankruptcy process yet, this will still be the case.

One more condition must be met, and that is that the total amount of unpaid bills must be equal to or more than the debt or debts that were forgiven. For example, if your liabilities are $10,000 higher than the value of your assets at their current fair market price and a lender cancels $10,000 or less of your debt, you won't have to pay taxes on the difference. However, if your insolvency is only $10,000 and the lender cancels $15,000 of your debt, the difference will be considered taxable income. You are required to record an extra $5,000 in expenses.

You are not required to record canceled debt as income if it is related to foreclosure, at least not until 2020. This exemption will remain in effect until the end of the year. This tax advantage was made possible by the Mortgage Debt Forgiveness Act; however, that legislation was allowed to lapse at the end of 2016. After that, the Bipartisan Budget Act of 2018 was extended retrospectively through the end of 2017. The Further Consolidated Appropriations Act of 2020 extended until the end of the fiscal year in 2020.

This assistance will now be available through the conclusion of the fiscal year 2025 due to the Consolidated Appropriations Act of 2021. Currently, the exclusion is capped at $750,000 (or $375,000 if you are married and filing separately). To be eligible, your primary house's mortgage must be paid.

Conclusion

You should wait to disclose a debt that has been discharged until after you have discussed the specifics of your circumstance with a tax specialist. You will want to be certain that you are required to declare the income in question. Also, until and until a tax expert notifies you that you do not need to include debt as income, you should plan on including it in that category.