Debt cancellation refers to the complete forgiving or releasing of a debt.  Depending on the circumstances, debt cancellation may be available to individuals as well as business entities.  Certain debts may not be cancelled or discharged, such as student loans.  Debt cancellation is also referred to by other names such as “Cancellation of Debt”, “Discharge of Indebtedness”, or “Discharge of Debt”.

Is Cancelled Debt considered to be Taxable Income?

If a debt that is owed is cancelled by the creditor, the amount of money that is forgiven is usually considered to be gross income for the debtor.  This means that the cancelled debt should be reported in tax statements and will be taxed as if it were income.

For example, suppose that a bank had lent $20,000 to a debtor, who then paid back the bank $15,000.  If the remaining $5,000 is cancelled by the bank, then that amount will be treated as taxable income for the debtor.

Some debts, even if discharged, may not be treated as taxable income.  Tax laws generally state that the following cancellations of debt are not treated as tax income:

  • Cancellation of debt occurring in a bankruptcy proceeding
  • Cancellation of debt where the taxpayer is insolvent
  • Cancellation of debt related to farm indebtedness
  • Cancellation of debt stemming from business real estate indebtedness

How are Gifts treated under Cancellation of Debt laws?

In order for a discharged debt to be considered taxable income, the debtor must have incurred what is called “true debt”.  True debt implies that the debtor has a legally enforceable obligation to repay the debt.

Not all financial transfers qualify as true debt.  Cancelled debt will not be considered income if it does not involve true debt.  A good example of this is with gifts.  Suppose your grandmother gives you a gift of $2,000.  Since this is a gift, there is no obligation to pay her back, and thus it is not a true debt.  Therefore there is technically no debt to cancel in this situation.

Can a Cancelled Debts be treated as a Gift and not Taxable Income?

In some instances, yes.  Taking our example above, suppose that, instead of giving it as a gift, your grandmother loaned you the $2,000, complete with a repayment schedule with interest.  This would be considered true debt.  However, if she discharges your duty to make payments, the cancelled payments could qualify as a gift in some jurisdictions.  You would not need to report the cancelled debt as taxable income because she is related to you.

Generally speaking, the treatment of cancelled debt as a gift only applies if the parties have a close personal relationship (i.e., they are relatives).  In a business context, cancelled debt may or may not be taxable income depending on whether the debt was considered to be debt or equity.   You may wish to consult with a lawyer for more advice on business debts.

What if my Debt has been Cancelled but the Creditor is now trying to Reclaim it?

There is no set test to determine whether a debt has been cancelled or not.  In general, debt cancellation is determined through an evaluation of the circumstances and facts relating to the transaction.  For example, a court may consider the prior dealings of the parties and how they dealt with debts in past interactions.

If you have received confirmation of a cancellation, this means that the creditor has legally released you from the debt.  They should not be able to demand repayment once they have agreed to issue a cancellation.

Therefore you should always obtain written confirmation if your creditor is canceling your debt.  You should not rely solely on oral agreements or spoken statements; instead you should request that the discharge agreement be finalized in writing so that it has legal effect.

You may consider having an attorney draft the cancellation document so that it includes all the relevant provisions.  The document may then be used as proof of the cancellation in the event that a lawsuit becomes forthcoming.

Do I Need a Lawyer for Disputes over Cancellations of Debt?

If you are facing a dispute over debt cancellation, you may wish to enlist the services of an experienced lawyer.  Your financial lawyers will be able to help you secure your interests and finalize any cancellation statements.  The laws covering discharges of debt may vary by region, so it is important to work with a lawyer who understands the laws of your particular jurisdiction.