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George Saenz, the Bankrate.com Tax Talk columnistTax bill for discharged debt

Dear Tax Talk,
I was told by an accountant that if I filed Chapter 7 bankruptcy, the amount of debt discharged could be counted as income when I file my taxes, thereby greatly increasing the amount of taxes I must pay. Is this true? I understand the repercussions of bankruptcy relief, but find it hard to understand why the IRS would feel that a person so strapped that Chapter 7 bankruptcy was the only option could afford to pay double the tax bill for the year.
-- Lisa

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Dear Lisa,
Your accountant only told you half the story. Bankruptcy is intended to give you a fresh start, and the tax laws do not run contrary to this intention. While it is true that the cancellation of indebtedness is considered income in a Chapter 7 bankruptcy, this income is not considered yours. If you are an individual debtor who files for bankruptcy under Chapter 7 or Chapter 11 of the bankruptcy code, a separate "estate" is created consisting of property that belonged to you before the filing date. This bankruptcy estate is a new taxable entity, completely separate from you as an individual taxpayer.

The estate, under a Chapter 7 proceeding, is represented by a trustee. The trustee is appointed by the bankruptcy court to administer the estate and liquidate your nonexempt assets. You, as the individual debtor, generally must file income tax returns during the period of the bankruptcy proceedings. Do not include on your return the income, deductions or credits belonging to the separate bankruptcy estate. Also do not include as income on your return the debts canceled because of bankruptcy. Publication 908 was last revised in 1996, but it is still a good source of information as you go through this difficult time. Although the publication may not need revising, you might consider revising the accountant.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.

Bankrate.com's corrections policy -- Posted: March 15, 2006
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