Cancellation of Debt


Cancellation of debt refers to the releasing or forgiving of a debt completely.  Cancellation of debt may be granted to individuals or businesses depending on the circumstances.  Cancellation of debt is also termed as discharge of indebtedness.  In Jones v. Cendant Mortg. Corp. (In re Jones), 396 B.R. 638 (Bankr. W.D. Pa. 2008), the court opined that the term “discharge-of-indebtedness” appearing in 26 U.S.C.S. § 61(a)(12) is interchangeable with the term cancellation of debt.  Discharge of indebtedness occurs for purposes of § 61(a)(12) when it becomes clear that the debt will not be paid.  The test for determining whether such an event has occurred is based on a practical assessment of the facts and circumstances relating to the likelihood of repayment.

A taxpayer is usually treated as realizing taxable income if a debt he/she owes is absolved or if it becomes unenforceable and it appears that such taxpayer will not pay the debt.  Pursuant to the Internal Revenue Code, the discharge of indebtedness shall be included in the gross income of a taxpayer.

In Hill v. Comm’r, T.C. Memo 2009-101 (T.C. 2009), the court stated that case law indicates that where indebtedness from a credit card account is being discharged and the amount of income as a result of the discharge equals the difference between the amount due on the obligation and the amount paid for the discharge or if no consideration is paid for the discharge, then the entire amount of the debt is considered the amount of income that the debtor must include in income.

In Stevens v. Comm’r, T.C. Summary Opinion 2008-61 (T.C. 2008), the court stated that “26 U.S.C.S. § 108(a) provides that a taxpayer may exclude income from the discharge of indebtedness if the discharge occurs in a bankruptcy case, or when the taxpayer is insolvent, or if the indebtedness is qualified farm or business real estate debt.”  Generally, a taxpayer should include income from the cancellation of debt.  However, certain cancelled debts shall not be included in gross income.  The exceptions are as follows:

  • If the cancellation of debt occurs in a bankruptcy case
  • When the taxpayer becomes insolvent
  • If the cancelled debt is a qualified farm indebtedness
  • If the cancelled debt is a qualified real estate business indebtedness.

A debt is said to be discharged or cancelled when the debtor is relieved of such debt or the payment obligation.  If it appears that the payment shall be enforced, then a debt is not deemed to be discharged or cancelled.  In McGowen v. Comm’r, T.C. Memo 2009-285 (T.C. 2009), the court stated that a discharge of indebtedness occurs when a taxpayer is no longer legally required to satisfy his debt either partially or fully.

Inside Cancellation of Debt