When someone borrows money from and they are later unable to pay that person back, and the person that loaned the money later decides to forgive that debt, the borrower will typically have to recognize income for tax purposes. However, there are some exceptions to when discharged debt will be considered income.

When Will “Discharge of Debt” Not Be Considered Income?

There are four situations where discharge of debt is not income to the taxpayer:

1. A debt discharged under the bankruptcy code by the court;
2. The taxpayer is insolvent
3. Debt discharged is qualified farm indebtedness
4. Debt discharged is qualified real property business indebtedness.

What Does It Mean to Be Insolvent?

For the purposes of this rule, a taxpayer is insolvent if their liabilities exceed the fair market value of their assets immediately prior to the debt discharge. Put simply, if someone owes more than the fair market value of what they own, they may be deemed insolvent.

What Happens If the Debt Discharged Is More than the Amount by Which the Taxpayer Is Insolvent?

The taxpayer will have to recognize income by the amount of debt discharged that exceeds the amount by which the taxpayer is insolvent.

For example: Joe has a debt of $100,000 and has $50,000 worth of assets. Before the debt discharge, Joe is insolvent for $50,000. Joe makes a deal to settle $80,000 of the debt for $20,000. Joe will recognize $10,000 in discharge of debt income because the $60,000 debt discharged ($80,000 – $20,000) exceeds the amount by which Joe is insolvent ($50,000) by $10,000.

What Is Qualified Real Property Business Indebtedness?

Qualified real property business indebtedness is a debt incurred or assumed in connected with a piece of real property used in a trade or business and that is secured by that piece of real property.

For debts incurred or assumed after 1992, the debt proceeds must be used to acquire, construct, reconstruct, or substantially improve the real property.

Similar to debt discharge for insolvent taxpayers, the amount that the taxpayer may exclude from income for discharge of qualified real property business indebtedness is limited to the amount of the outstanding principle of the debt that exceeds the fair market value of that real property.

Can Discharge of Student Loans Be Excluded from Income?

Yes, but only to a limited group of student loans. There is a special rule that applies to the discharge of student loans. A taxpayer may be able to exclude part or all of their discharged student loans if:

  • The loan agreement provides the loan may be discharged
  • The borrower works for a specific period of time in certain profession for any of a broad class of employers in exchange for the discharge.

For the purposes of this rule, only the following student loans qualify for this exclusion:

  • Loans from federal, state, or local government
  • Loans from certain tax-exempt public benefit corporation
  • Loans from certain educational institutions.

Are There Exceptions to the Discharge of Debt Income Exclusion Rules?

There are several exceptions to the general discharge of debt rule; two notable exceptions include:

1. There is no income if the debt that was discharged would have been deductible had it been paid.
2. When a seller sells property to a buyer on credit, the buyer can treat the debt discharged by the seller as a purchase price adjustment to the property bought.

Do I Need an Attorney to Help Me with My Tax Problems?

Tax laws are complex and ever-changing. Although there are various tax preparation software programs on the market, nothing can provide the same level of service that a knowledgeable tax attorney can. If you are unsure about the characterization of your losses or if you need someone to represent you before the IRS, you should strongly consider consulting with a tax attorney.