When you obtain bankruptcy relief, you are essentially receiving a financial benefit, because most, if not all, of your debts will be wiped away. The tax consequences of debt relief differ greatly depending upon whether the debt is discharged through bankruptcy or settled outside of bankruptcy.
Settlements Out of Bankruptcy
The Internal Revenue Service recognizes the financial benefit where debts are settled outside of bankruptcy, and generally considers any financial benefit as taxable income.
For example, if you settled a $5,000 credit card debt for $2,000, you must pay income tax on the $3,000 you saved pursuant to the settlement. The creditor will most likely report this settlement to the IRS, and will also send appropriate tax documents to you.
However, if a debt is discharged in bankruptcy, the IRS makes an exception to the general rule and does not consider it taxable income.
The tax considerations of negotiating a debt outside of bankruptcy must be weighed against the consequences of a bankruptcy.
Simply avoiding a bankruptcy by settling accounts with creditors might not be the better option, particularly if all debts will be dischargeable through bankruptcy anyway.
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