Debt Discharge

What Is Debt Discharge?

Debt discharge is the cancellation of a debt due to bankruptcy. When a debt is discharged, the debtor is no longer liable for the debt and the lender is no longer allowed to make attempts to collect the debt. Debt discharge can result in taxable income to the debtor unless certain IRS conditions are met.

Understanding Debt Discharge

When a debt is discharged, it is the result of a bankruptcy ruling. During a Chapter 7 (for individuals) or Chapter 11 (for businesses) bankruptcy, if the debtor meets all of the conditions given by the court, they may have their debt discharged by the court. When debt is discharged through a bankruptcy court, the lender can no longer make attempts to collect the debt and the debtor is no longer responsible for paying it back.

Debt discharge often results in taxable income to the debtor unless the forgiveness is a gift or bequest, but some bankruptcy discharges can be exempt from taxes if the debtor meets IRS requirements.

There are several ways that a debtor can be forgiven a debt. The two most common are when a debt is canceled or when a debt is discharged. When a debt is canceled by an institution, the institution decides they will likely not collect the debt and the remaining amount owed is forgiven. The debtor will usually receive a Form 1099-C that shows the amount of debt forgiven. The debtor must then report this as miscellaneous income on Form 1040 and is required to pay income tax on the amount of the discharged debt, since having the debt discharged is the same as getting to keep the money, making it a source of income.

The debtor must file Form 982 with the IRS, which can negate the taxation of the discharged debt if certain conditions are met. The institution can receive a bad debt write-off for the amount of the debt uncollected, which gives them a break on their taxes. 

Special Considerations

Usually, a judge decides whether or not to discharge a debt in bankruptcy and can refuse to discharge a debt if:

• The debtor disobeyed court orders
• The debtor failed to undergo financial counseling or education
• The debtor failed to keep adequate records
• The debtor failed to satisfactorily explain the loss of any of their assets
• The debtor committed a crime
• The debtor lied or otherwise submitted fraudulent information during the proceedings

In addition, not all debtors qualify for Chapter 7 bankruptcy. Those who are earning a high monthly wage or who have large amounts of consumer debt may be required to file Chapter 13 bankruptcy, in which debts are not discharged, but are restructured so that the debtor can regain control of his or her finances and pay off the debts. In this way, the law sets up barriers to keep consumers from racking up debt and then filing bankruptcy to avoid paying it off.