Discharged or Forgiven Debt Income Text Size:

In figuring out your income taxes, you start with your gross income. Adjustments are made to this number to arrive at your taxable income, and you can then calculate the tax you owe. Discharge of indebtedness income is included in the broad definition of gross income. There are many sources for discharge of indebtedness income, and some exceptions to the rule that it must be included in your gross income.

Gross Income Defined

The Internal Revenue Code defines gross income as all income from whatever source derived, or additions to wealth. Discharge of indebtedness income is included in gross income according to Internal Revenue Code § 61(a)(12). You have discharge of indebtedness income when a debt is cancelled or forgiven, or if a creditor accepts less than the full amount of the unpaid balance on your debt as payment in full on your obligation. The amount of gross income is the difference between the amount of the debt being cancelled and the amount paid to settle the debt.

The concept of discharge of indebtedness income can be explained under the "loan proceeds theory." If you receive funds from a loan, the funds are not included in your gross income because under your loan terms, you have to repay the money. You haven't received an addition to your wealth. You'll either repay the loan or the debt will be cancelled or forgiven, in which case you might have income from the discharge of indebtedness.

Determining if a Discharge of Debt Is Income

You must have a true debt to have income from discharge of indebtedness, and to qualify to exclude that income from your gross income as allowed by Internal Revenue Code § 108. You have a true debt if there is an unconditional and legally enforceable obligation to repay the money. The amount of income is generally the difference between the amount of the debt being cancelled, reduced by what you've already paid, and the amount paid for the complete settlement of the debt.

Income from Discharged Debt or a Gift?

Not all transfers of money or property are true debt, or result in gross income if there's a cancellation of true debt because the transfer of value to you is a gift. For example, your mother gives you $1,000. It's not a true debt because you have no obligation to pay her back. It's a gift. Even if you have a loan, it's possible that the cancellation or forgiveness of the debt won't result in income, because the amount of the cancelled debt might qualify as a gift.

Let's say your mother loaned you money, with a schedule of payments and interest, but she refuses your payments. It's possible that your mother's cancellation of your duty to make payments will qualify as a gift under tax laws. The result? You won't have discharge of indebtedness income to report on your taxes. This treatment of the cancellation of debt as a gift typically applies only if the lender and the borrower have a personal relationship, like being family members, because it's unlikely that a nonrelated lender would just give you a gift.

True Debt for Businesses

In a business context, the question is whether a transfer of money or property is debt or equity. A transaction could be viewed as a true debt, and discharge of indebtedness income could result if the debt is later cancelled. A transfer could also be viewed as equity, a contribution of capital to a business, and the transfer isn't debt. For example, an exchange of partnership debt for equity or interest in the partnership shouldn't result in discharge of indebtedness income. There are many factors considered in deciding whether a transaction is equity or debt, and the answer isn't always clear-cut. How other financial transactions and issues are treated by a business can affect whether a transaction is characterized as debt or equity. A taxation lawyer can help you assess your situation.

Mortgages and Forgiven Debt

The Mortgage Forgiveness Debt Relief Act of 2007 may provide relief and allow you to exclude forgiven debt income if it's due to a discharge of debt against your home. Income from restructuring your mortgage and forgiven debt is included. This law applies to debt forgiven between 2007 and 2012, and on amounts up to $ 2,000,000; $1,000,000 if you're married filing separately. You must have taken on the debt to buy, build or substantially improve your home. This is also called "qualified principal residence indebtedness." Debt used to refinance your home can qualify.

The American Recovery and Reinvestment Act of 2009

The American Recovery and Reinvestment Act of 2009 also provides relief for taxpayers facing cancellation of debt income. The law adds a provision that permits a taxpayer to elect to defer cancellation of indebtedness income arising from a reacquisition of an applicable debt instrument after December 31, 2008, and before January 1, 2011. The deferred income is later recognized over a five-year period. Debt-for-debt exchanges are also addressed. Taxpayers have a tax planning option; they can elect to defer income from a discharge of indebtedness under Internal Revenue Code § 108 instead of excluding the income and reducing tax attributes.

Questions for Your Attorney

• I borrowed money from my parents, and they tell me to keep my annual payments as gifts. Is this correct or do these forgiven loan payments have to be reported somewhere on my tax forms?
• What issues do shareholders or members of a partnership need to consider when there's a discharge of business debt? Can you help me to structure transactions for my business to avoid tax issues down the road?
• Is it always clear when there is discharge of indebtedness income? How is this measured - is there income on the date when each periodic loan payment is cancelled, for example?

Related Resources on Lawyers.com^sm