Most people do not know that there can be a tax implication when debt is forgiven by a creditor. Many debtors will attempt to reach an agreement with their creditors to only pay back a portion of the debt owed. The debt that is “forgiven,” or written off, then becomes income to the Debtor in the eyes of the IRS. The Debtor must then pay taxes on that “income.”
One of the benefits of bankruptcy is the debt is discharged with no tax implications. The law specifies that a discharged debt cannot be collected, and that inludes being collected by the IRS. Another common scenario is when a house if foreclosed on, and the Debtor is upside down on the mortgage. There is usually a deficiency that remains. That deficiency is also considered income and must be claimed as such under the Tax Laws. This can then cause many people to owe the IRS money, which in most instances, would not be a dischargeable debt.