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Cancellation of Debt, Taxes, and Insolvency

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    Cancellation of Debt, Taxes, and Insolvency

    This is probably an advanced topic but I'm wondering if in certain instances, like in mine where I'm currently insolvent, have home equity, an inheritance coming in an undetermined amount, and a settlement in a lawsuit in an undetermined amount, could it possibly beneficial from a tax standpoint to settle inside of bankruptcy rather than outside?

    For instance, I have claims against mortgage servicer and owner that I can bring in federal court now and perhaps settle those claims for a cash award or debt forgiveness (modification, reformation of contract) or I could bring those claims as defenses in recoupment in bankruptcy and have the debt reduced that way. I think the difference is the tax liability.

    I'm looking at this specifically: 26 U.S.C. § §108. Income from discharge of indebtedness

    (a) Exclusion from gross income

    (1) In general
    Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

    (A) the discharge occurs in a title 11 case,

    (B) the discharge occurs when the taxpayer is insolvent,

    (C) the indebtedness discharged is qualified farm indebtedness,

    (D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or

    (E) the indebtedness discharged is qualified principal residence indebtedness which is discharged—

    (i) before January 1, 2021, or

    (ii) subject to an arrangement that is entered into and evidenced in writing before January 1, 2021.

    Many people may not know this but if you win a lawsuit, you have to pay taxes on the entire amount, including the attorney fee or contingency fee as well. So if you're attorney recovers $25,000 for you and his fees are $50,000, you must pay taxes on $75,000. This doesn't always apply to some personal injury and employment cases.

    In my case, timing is everything. Also interested to see what comes of debt forgiveness in upcoming modifications (think HAMP.) Because sometime in 2015, debt forgiveness in a loan modification is considered cancellation of debt income.


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