In a typical bankruptcy, the case ends with a discharge of indebtedness. You no longer owe the $20,000 you once owed to Capital One, but how does this affect your next tax return? Essentially, it doesn’t.
Cancellation of debt income (CODI) is typically taxable. The creditor will send you a 1099-C, showing the amount of debt that was cancelled, and the cancelled amount is reported on your tax return as income. This can increase the amount of taxes you owe or decrease any refund you may receive.
But some cancelled debt is excluded from taxable income under 26 U.S.C. § 108. One exclusion provides that if a debt was discharged in a bankruptcy, the amount is not to be included as gross income. If a creditor sends a 1099-C for a debt that was discharged in bankruptcy, the taxpayer reports the income on the tax return and files Form 982 to exclude that amount. Basically, you need to tell the IRS that you received a 1099-C, but the amount isn’t taxable because of your bankruptcy discharge. (Yes, it would be easier to just ignore the income. But tax forms aren’t known for being easy.)
Keep in mind that debt settlements *may* result in taxable CODI. If Bank of America agrees to settle your $25,000 debt for a lump sum of $10,000, you may end up having to pay income tax on an extra $15,000. If you are negotiating a debt settlement, be sure to factor in the possible tax consequences before you finalize a deal. (Funny how most debt settlement companies never tell you about this…)
So far as refunds go, as long as you can exempt the right to receive a tax refund, you will be able to keep it. If you can’t exempt it, your attorney may have some options for protecting it. Most of my clients keep 100% of their tax refunds, but this will vary depending on where you file your bankruptcy.
If you have any questions about how your bankruptcy will affect your tax return, ask your bankruptcy attorney or tax professional.