When a creditor writes off or writes down your debt, they frequently tell the IRS that you’ve received income for the amount written off. Called “discharge of indebtedness” income it’s a terrible trap for debtors/taxpayers because under the Internal Revenue Code this income can be taxed. There are two exceptions worth thinking about: First, if you were insolvent at the time that your creditor wrote off that debt, then you won’t have to pay tax on it; simply include a schedule with your tax return showing the IRS that your debts, which include the debt that was written off, were higher than your assets at that time.
But a better way to avoid having a problem with the IRS is to discharge debt in bankruptcy. The Internal Revenue Code provides that debts discharged in bankruptcy aren’t included in taxable income. That’s why it may be a better choice to file bankruptcy to discharge a sizable debt instead of negotiating with the creditor for relief. If that creditor is a bank they’ll likely send a 1099 to the IRS reporting the debt written off as income to you, but by discharging that same debt in bankruptcy that can’t happen.
