Can Chapter 7 Forgiveness Result in an IRS Gift Tax?
The IRS considers forgiven debt to be taxable income. However, a Chapter 7 discharge is not forgiven debt for income tax purposes. In fact, one of the benefits of a Chapter 7 discharge is that the IRS will not tax you on the discharged debt. The IRS will also not charge a gift tax, since a gift tax is assessed against a person who makes a large monetary gift to another person.
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Gift Tax
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The IRS assesses a gift tax when you give away money or property but receive little or nothing in return. The IRS may even assess a gift tax if you make an interest-free loan or sell something for less than what it's worth. Gift taxes do not apply to a gift you receive; a monetary gift you receive is subject to income tax, not gift tax. Gift taxes generally have no application to a Chapter 7 bankruptcy discharge, however, even though you are getting rid of debt.
Chapter 7 Discharge is Not Debt Forgiveness
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Debt forgiveness occurs when one of your creditors voluntarily agrees to accept less than what you owe in full settlement of a debt, or when a creditor voluntarily agrees to forgive a debt entirely. A Chapter 7 discharge is a court-ordered release of your liability to repay certain debts. Chapter 7 bankruptcy is federally mandated, and most of your creditors have little choice in the matter. After a Chapter 7 discharge, your debt still exists; you simply don't have to pay it back. In that regard, the discharge is not a debt forgiveness; unless a creditor can accuse you of fraud or a debt is nondischargeable; the discharge wipes out your obligation to repay whether or not the creditor wants it to.
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Debt Forgiveness is Taxable Income
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If a creditor forgives a debt, the amount of the forgiven debt is income to you. The IRS will assess taxes on debt forgiveness, whether a mortgage company forgives debt after a foreclosure or whether you enter into a debt settlement arrangement, although there are exceptions for certain foreclosed mortgages, nonrecourse loans and people who are insolvent at the time the creditor forgives the debt. Debt forgiveness is taxable as income because when you owe money and the creditor forgives it, the effect is the same as someone giving you that amount. For example, if you owe $20,000 and the creditor forgives the debt, it is as if the creditor gave you $20,000; therefore, the IRS will assess tax on that $20,000.
Chapter 7 Discharge is Not Taxable Income
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The Chapter 7 discharge is not taxable income. The IRS will not tax you on any debt you discharge in your Chapter 7 case. Even if you discharge hundreds of thousands of dollars in unsecured debt, you don't have to pay one cent in taxes on the discharge.
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