Taxation of Debt Forgiveness And Insolvency

The Internal Revenue Code provides that a cancellation of indebtedness is taxable income. Thus if you settle a $10,000.00 credit card debt for $5,000 you will have to pay income tax on the $5,000 forgiven.

Like most general rules this one has exceptions.   One exception is that a debt discharged in bankruptcy will not produce taxable income, and as a bankruptcy lawyer  I can say that without this rule very few debtors would actually receive the fresh start that bankruptcy is intended to confer.

Even if one does not go bankrupt though the forgiveness will not be taxable, if the debtor remains insolvent.  Thus if after the $10,000 is forgiven the debtor still has $30,000 of additional debt and has no property there will be no taxable income, because the debtor is still insolvent by $30,000.

One pitfall that is sometimes overlooked though is that the insolvency calculation requires the taxpayer to include  some items that he or she might not normally think of as property, such as assets in a 401k or a pension plan.  In trying to figure out if someone is insolvent with a pension one would of course have to figure out the present value of future pension benefits which very few people know how to do.  Unfortunately, some judges have even thrown out the insolvency exception just because the debtor had a pension that he was unable to calculate a value for.  The theory was that unless they could show the value of the pension the taxpayer would be unable to meet his burden of proof that he is indeed insolvent.