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Reduce Your Tax Hit By Filing Bankruptcy Rather Than Settling Debts

By Cathy Moran

debt settlement can increase taxes

Settle your debts outside of bankruptcy and you may be bitten by taxes you didn’t expect years later.

Yet, everyone I talk to would rather cut a deal with their creditors than file bankruptcy.  It’s universal.

But here’s the killer reason why bankruptcy alone protects homeowners from a unexpected  tax consequence down the road.

Debt forgiven outside of bankruptcy may be deducted from the basis of your home.   Result:  more potentially taxable capital gains on sale.

It works like this.

Debt settlement increases taxes two ways

Debt forgiven in bankruptcy or while insolvent gets an exception from the standard tax rule that cancelled debt is taxable as income.  IRC 108. So, if you are insolvent, by the IRS measure, a negotiated settlement doesn’t trigger immediate, taxable income.

But that tax benefit comes with a delayed cost.  The amount of the debt forgiven is deducted from the basis of your assets.

So if the tax basis in your home was $200,000 and the debt that was discharged or settled was $200,000, you end up with a house with zero basis.

Sell that house and every dollar you receive is gain, and potentially subject to tax.  Ouch!

Special tax rule for homes in bankruptcy

But wait! Wait!  There’s an exception to the reduction of basis rule that shields your principal residence from reduction in basis when debt is forgiven. 

But that exemption applies only if  your debt was cancelled in bankruptcy and you claimed your home as exempt.

So, the basis in your home is not reduced if the debt was forgiven in bankruptcy, rather than an out-of-court settlement, and you claimed an exemption.   IRC 1017(c),

So, when you consider your alternatives for getting yourself out of debt, homeowners need to look beyond this year’s tax return to the point at which they may sell their house.  Every dollar in basis excludes that dollar from being taxed as capital gain.

More

How tax exception for forgiven debt works

The ugly truth about debt settlement

How bankruptcy deals with taxes

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Filed Under: Considering Bankruptcy, Consumer Rights, Taxes Tagged With: 2018, cancellation of debt tax

About Cathy Moran

I'm a veteran bankruptcy lawyer and consumer advocate in California's Silicon Valley. I write, teach, and speak in the hopes of expanding understanding of how bankruptcy can make life better in a family's future.

Bankruptcy Basics

About The Soapbox

You’ve arrived at the Bankruptcy Soapbox, a resource of bankruptcy information and consumer law.

Soapbox is a companion site to Bankruptcy in Brief, where I try to be largely explanatory and even handed (Note I said “try”).

Here, I allow myself to tell stories and express strong opinions. We dig deeper into how to consider bankruptcy and navigate a bankruptcy case.

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Bankruptcy specialists for individuals and small businesses in the San Francisco Bay Area

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