When Is a Discharge of Indebtedness Not Included in Gross Income?

When a lender forgives a debt, the Internal Revenue Service (IRS) considers the canceled amount as income to the borrower because the borrower has received an economic benefit. The tax code provides several specific exceptions, or exclusions, that allow a taxpayer to avoid including the discharged debt in their gross income. These provisions recognize that debt cancellation often occurs during times of financial hardship and provide relief from an associated tax burden.

The General Rule for Canceled Debt

The foundation of taxing canceled debt is that when a person borrows money, it is not income because of the obligation to repay it. Once that obligation is legally discharged for less than the full amount, the borrower has realized an increase in their net worth. The forgiven amount is no longer a liability, which the IRS views as income applicable to credit card balances, auto loans, and personal loans.

Lenders who cancel $600 or more of a debt must issue Form 1099-C, Cancellation of Debt, to both the borrower and the IRS. This form details the amount of debt discharged and the date of cancellation. The amount shown in Box 2 is the amount that must be reported as “Other Income” on Form 1040, unless a specific exclusion applies.

Primary Exclusions from Gross Income

Bankruptcy

A significant exclusion applies to debts discharged in a Title 11 bankruptcy case. A Title 11 case is any proceeding under the U.S. Bankruptcy Code, including Chapter 7, Chapter 11, and Chapter 13. When a court grants a discharge under these chapters, the canceled debt is not considered taxable income.

This exclusion is comprehensive, as the full amount of the debt discharged within the proceeding can be excluded. The debt cancellation must be a direct result of the bankruptcy case, meaning it is granted by the court or occurs under a plan approved by the court.

Insolvency

An exclusion applies if a taxpayer is insolvent immediately before the debt is canceled. Insolvency for tax purposes is a financial state where a person’s total liabilities are greater than the fair market value of their total assets. To determine insolvency, a taxpayer must calculate the market value of all assets and list all liabilities right before the cancellation, including assets exempt from creditors like retirement accounts.

The amount of canceled debt that can be excluded is limited to the amount by which the taxpayer is insolvent. For example, if a person has liabilities of $70,000 and assets of $50,000, they are insolvent by $20,000. If a creditor cancels a $25,000 debt, the taxpayer can exclude $20,000 of it, and the remaining $5,000 is taxable income unless another exclusion applies. IRS Publication 4681 provides a worksheet for this calculation.

Qualified Principal Residence Indebtedness

An exclusion exists for forgiven debt related to a qualified principal residence, which has been extended through 2025. The exclusion applies to debt used to buy, build, or substantially improve a main home and must be secured by that residence. This can include refinanced mortgage debt, but only up to the amount of the original mortgage principal.

For debt discharged through 2025, the maximum amount of forgiven debt that can be excluded is $750,000. For a married individual filing a separate return, this limit is $375,000.

Certain Student Loan Discharges

The American Rescue Plan Act of 2021 created a broad, temporary exclusion for student loans. Under this act, the discharge of most federal and private student loans between January 1, 2021, and December 31, 2025, is not treated as taxable income for federal tax purposes. This provision covers a wide range of postsecondary education loans, whether from the government, the educational institution, or a private lender.

Individuals benefiting from programs like income-driven repayment plans will not face a federal tax liability on the amount forgiven during this period. However, some states may not conform to this federal treatment, potentially making the discharged amount taxable at the state level.

Business and Real Estate Related Exclusions

Qualified Farm Indebtedness

An exclusion is available to farmers for the cancellation of qualified farm indebtedness. To qualify, a taxpayer must meet a gross receipts test where more than 50% of their aggregate gross receipts for the three prior tax years must come from the business of farming. The debt must have been incurred directly in connection with operating the farming business.

The lender must also be a “qualified person,” meaning an entity like a bank or government agency that is regularly engaged in lending and not related to the taxpayer. The amount of canceled farm debt that can be excluded is limited and cannot exceed the sum of the taxpayer’s adjusted tax attributes and the basis of certain business property.

Qualified Real Property Business Indebtedness

Taxpayers other than C corporations can elect to exclude canceled qualified real property business indebtedness from their income. This refers to debt incurred or assumed in connection with real property used in a trade or business and secured by that property, such as debt to acquire or improve commercial real estate. This exclusion is not automatic, and the taxpayer must make an election to use it.

The amount of debt that can be excluded under this rule cannot exceed the taxpayer’s total adjusted basis in depreciable real property. The consequence of this election is a required reduction in the basis of the taxpayer’s depreciable real property, which defers the tax.

Required Tax Reporting for Exclusions

When a taxpayer qualifies to exclude canceled debt from income, they must report this action to the IRS by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. This form is attached to the federal income tax return for the year the debt was discharged. On Part I of the form, the taxpayer checks the box for the specific exclusion being claimed and enters the amount of discharged debt being excluded.

The trade-off for excluding canceled debt from income under most of these provisions is the required reduction of certain tax attributes. Tax attributes are favorable tax items that could otherwise reduce tax liability in future years. By reducing them, the tax benefit of the debt cancellation is partially deferred rather than completely eliminated.

For exclusions due to bankruptcy or insolvency, the IRS mandates a specific order for reducing these attributes. The reduction is dollar-for-dollar for losses and basis, but for most tax credits, the reduction is 33⅓ cents for each dollar of debt excluded. The required order of reduction is as follows:

• Net operating losses (NOLs)
• General business credit
• Minimum tax credits
• Net capital losses
• Basis of property