Some people ask me, if I file bankruptcy and obtain a discharge of debts in bankruptcy, do I owe income taxes on the forgiven debts? The answer is no.
Under the Internal Revenue Code, 26 U.S.C. sec. 108, you do not owe income tax if a debt was cancelled in bankruptcy. Outside of bankruptcy, the general rule is that yes, you can owe taxes if someone forgives a debt that you owe. For example, let's say that you owe Citibank for a credit card debt of $10,000.
If you settle with Citibank, and pay them $3000 to settle the debt, they can send the IRS a 1099 Form showing that they forgave $7,000 in debt to you. And that $7,000 is additional income to you that you must report on your tax return. But if instead of settling the debt, you filed bankruptcy, so that the $10,000 debt was completely cancelled and discharged in bankruptcy, and you had to pay them nothing, then you owe no tax at all.
There are certain other exceptions to the income from cancellation of indebtedness rule, the most common being insolvency. If you were insolvent when the debt was cancelled, then you will not owe tax, at least up to the amount by which you were insolvent.
There are certain other exclusions, you can get IRS Form 982 on their website at www.irs.gov, and it lists the other exceptions. However, if you have tax attributes, such as a capital loss carryforward, if you have debts discharged in bankruptcy, your tax attributes are reduced.
This is a very complicated area and you should consult a tax professional that is familiar with all of these rules and how they impact your particular situation. For more general information, see IRS Publications 334, 523, 544, 551, 908, 4681, and 4702. I offer a free consultation for people that have serious debt or tax problems, if they live in the Houston Texas metro area. Please call my main telephone number, 713-772-8037 for an appointment.