Compass Newsletter - Articles

A Lesson in Forgiveness:
When is Discharge of Indebtedness Income Taxable?

By Tricia M. Olson
(Winter 2010)

When a creditor cancels or forgives all or a portion of a debt, the debtor has discharge of indebtedness income. Generally, discharge of indebtedness income is taxable. There are a number of exclusions, however, to this general rule. This article summarizes some common exclusions for debtors facing foreclosure or restructuring debt.

  1. Nonrecourse Debt.

    The debtor’s tax treatment of a foreclosure differs depending on whether the debt is recourse or nonrecourse. A debt is “nonrecourse” if the creditor is limited to repossession of the collateral when the debtor defaults. In contrast, a debt is “recourse” if the creditor can hold the debtor personally liable even after repossession and sale of the collateral.

    If the debt is recourse, the debtor (1) realizes gain from the transaction to the extent that the fair market value of the collateral exceeds basis, and (2) recognizes discharge of indebtedness income to the extent that the debt exceeds the fair market value of the collateral. If the debt is nonrecourse, the debtor does not recognize discharge of indebtedness income, but may realize gain if the debtor’s basis is less than the greater of (a) the fair market value of the collateral or (b) the full amount of outstanding debt.1

    The difference in these calculations is illustrated by the following example:

    Assume that Debtor owns a commercial building with a fair market value (“FMV”) of $550,000 and a tax basis of $250,000. The balance of the mortgage on the building is $700,000. The mortgage lender forecloses.

    If the mortgage was recourse, Debtor would have a $300,000 taxable gain ($550,000 FMV less $250,000 basis) plus $150,000 of discharge of indebtedness income ($700,000 mortgage balance less $550,000 FMV). The discharge of indebtedness income is taxed as ordinary income.

    If the debt was nonrecourse, Debtor would have a $450,000 taxable gain ($700,000 mortgage balance less $250,000 basis), but no discharge of indebtedness income.

  2. Qualified Farm Indebtedness.

    A debtor may exclude discharge of qualified farm indebtedness from taxable income.2 Two requirements apply: (1) the debtor must have incurred the indebtedness directly in connection with the debtor’s operation of the trade or business of farming, and (2) 50% or more of the debtor’s total gross receipts for the three years preceding the discharge must be attributable to the debtor’s farming operation.3 The exclusion cannot exceed the debtor’s basis in the qualified farm property.

  3. Qualified Real Property Business Indebtedness.

    A debtor that is not a C corporation may elect to exclude income from the discharge of qualified real property business indebtedness.4 For this exclusion, qualified indebtedness is debt incurred to acquire, construct, reconstruct, or substantially improve real property used in a trade or business.5 The debt must be secured by the real property, and the debtor must elect on its tax return to treat the debt as qualified real property business indebtedness.

  4. Qualified Principal Residence Indebtedness.

    For the years 2007 to 2012, debtors may exclude up to $2 million of income from the discharge of qualified indebtedness on their principal residence ($1 million if married and filing separately).6 Qualified indebtedness, for purposes of this exclusion, is any debt incurred in acquiring, constructing or substantially improving a principal residence. The debt must be secured by the principal residence. A debtor can have only one principal residence at a time.

  5. Bankruptcy or Insolvency.

    Debt cancelled in a bankruptcy case is generally excluded from the debtor’s taxable income.7 For this exclusion to apply, the debtor must be under the jurisdiction of the bankruptcy court and the discharge of indebtedness must be ordered by the court or be pursuant to a plan approved by the court.

    Similarly, a debtor may exclude discharge of indebtedness income if the discharge occurs when the debtor is insolvent, even though the debtor does not file bankruptcy.8 A debtor is insolvent if the debtor’s liabilities exceed the fair market value of his or her assets. The amount excluded cannot exceed the amount by which the debtor is insolvent, as illustrated by the following example:

    Debtor was released from his obligation to pay a $50,000 debt. Immediately before the cancellation, the FMV of Debtor’s total assets was $500,000, and his total liabilities were $525,000. Debtor is insolvent to the extent of $25,000 ($525,000 total liabilities less $500,000 total assets). Debtor can exclude only $25,000 of the $50,000 discharge of indebtedness income under the insolvency exclusion.

  6. Election to Defer.

    The American Recovery and Reinvestment Act of 2009 allows business debtors to elect to defer certain discharge of indebtedness income arising from a reacquisition of “applicable debt instruments” in 2009 and 2010.9 An “applicable debt instrument” means debt issued in connection with the conduct of a trade or business. The deferral lasts until 2014, at which time the debtor must recognize the discharge of indebtedness income proportionately over five years. The deferral is accelerated, however, if the debtor (1) dies, (2) liquidates or sells substantially all of its assets, or (3) ceases to do business. Once made, the election is irrevocable.


Generally, if a debtor uses any of the above-described exclusions, the debtor must reduce basis and other tax attributes (i.e. capital loss carryovers, tax credit carryovers) by the amount of the excluded discharge of indebtedness income. Further, use of one of the exclusions may preclude use of a different exclusion and may lead to other tax consequences. Careful tax planning is necessary, therefore, to determine what steps to take in the event of pending insolvency, bankruptcy, foreclosure, debt restructure, or similar issues.

1 Reg. 1.1001-2(a)(1)-(2)
2 IRC 108(a)(1)(C)
3 IRC 108(g)(2)
4 IRC 108(a)(1)(D)
5 IRC 108(c)(3)-(4)
6 IRC 108(a)(1)(E); 108(h)
7 IRC 108(a)(1)(A)
8 IRC 108(a)(1)(B)
9 IRC 108(i)