IRS Section 108 or Cancellation of Debt May Not Be So Bad

Out of fear of beating a dead horse, I hesitate to raise the issue of forgiven debt again.  However, I am seeing alot of questions related to this issue from people facing foreclosure and settling credit card debt, and want to make the issue and solution more clear.

The cancellation of debt (COD) or forgiveness of income is taxable income under the principles set forth in IRC Section 61(a)(12). Absent some exception cancellation,  the COD or forgiveness of debt is income to the individual.

However, section 108 of the Tax Code provides a variety of exceptions to the general rule of Section 62(a)(12), most importantly Section 108(a) which excludes cancellation of debt to the extent of insolvency.

For purposes of the insolvency exception of Section 108(a), the term insolvent means the excess of liabilities over the fair market value of the taxpayer's assets immediately before the cancellation event. IRC Section 108(d)(3). Therefore if you don't have assets that are worth more than your debts prior to the COD you don't have income. 

Many individuals are "insolvent" according to this definition, and should ask their accountant about the attachments necessary when filing the return, to ensure that the IRS does not treat the debt cancellation as income.

If the individual files a bankruptcy before the COD event occurs, the bankruptcy acts as an exception to IRS section 61 as well.