Generally, the IRS regards canceled, discharged, and forgiven debt as taxable income because the debtor received a benefit without paying for it. However, there are a few exceptions:
- Debt discharged in a Title 11 bankruptcy (including chapters 7, 11, and 13)
- Canceled debt on qualified farms and real business property
- Forgiven debt on a qualified principal residence (aka mortgage forgiveness debt relief)
- Debt canceled due to insolvency
- To qualify, you must demonstrate that your total debt exceeded the fair market value of all of your assets immediately before the cancelation occurred.
- Use the Insolvency Worksheet in IRS Publication 4681 to figure out if you were insolvent at the time of the debt cancelation.