In order to cancel or discharge a debt, the debtor must be relieved of his payment obligation. For effecting the cancellation of debt, a possibility of enforcement of payment should not exist. Cancellation of debt income exists when-
- a creditor accepted less than full face amount of balance due even though property securing taxpayer’s mortgage notes had been completely destroyed by hurricane in an earlier year;
- a taxpayer prepaid his mortgage at a discount; and the statute of limitations barred a creditor from instituting a debt collection suit.
- a shareholder dies before repaying a loan from his corporation, and in effect the debt is forgiven, his estate can be taxed on the loan amount as cancellation of debt income.
Any person paying the tax is treated as realizing taxable income:
- If a debt he owes is forgiven,
- If it is unlikely ever to be enforced against him, or
- If it becomes unenforceable against him and the indications are that he won’t pay it.
The taxation of cancellation of debt income to the debtor depends on whether the debtor is solvent, insolvent, or bankrupt. However, all cancellation of indebtedness does not result in cancellation of debt income. Debt discharge may also be in the form of compensation. Discharges by financial institutions and government agencies of non-business debt of individuals whose principal home was in the Hurricane Katrina disaster area are excluded from gross income.
For the existence of a cancellation of debt income, there has to be a legal debt, and a debtor creditor relationship between the parties. In case of a dispute regarding whether a taxpayer owes any part of an alleged debt, a later settlement of the dispute is treated as the amount of the debt, and it won’t give rise to cancellation of debt income.