What is Cancellation of Debt?

This question comes up a lot and there are many different and confusing answers available on the internet.  The term was coined by our beloved Internal Revenue Service as a means of taxing the benefit received by a tax payer when he, she or it is relieved of paying back a loan.

The IRS takes the position that not having to repay a loan is a taxable event, and we should pay tax on the money that we can now keep.  Thus, if you are forgiven from paying back $100,000 loan, that amount can be added to your income for the year to compute your tax obligation.  This is true even if you are not paying the loan because it was on a house that has been foreclosed, or property you have surrendered and no longer have.

There are several ways to avoid this problem depending on the type of debt that was cancelled.  Generally, you must show that you were insolvent at the time of the debt cancellation.  This is easy to do if you file bankruptcy.  The best explanation of this can be found on the Internal Revenue Service’s web site.  It’s actually a great resource for answering tax questions.