Cancellation of debt by a creditor can create taxable income for the person(s) who had agreed to pay the debt (debtor). This is often also called forgiveness of debt or compromise of debt. Creditors are required to report to the Internal Revenue Service debt that is “written off” as not collectible.

The amount of debt written off may need to be included in a debtor’s income for income tax purposes. There are four primary exceptions to the requirement that the cancelled debt be included in income under Internal Revenue Code Section 108:

  • The debt was discharged in bankruptcy;
  • The forgiveness, cancellation or other compromise of the debt that does not make the debtor solvent;
  • The debt is a qualified farm debt;
  • The debt is qualified real estate business indebtedness

A person is solvent when you own more assets than you owe in debt. Failure to report the compromised debt outside bankruptcy will often result in the IRS demanding that you pay taxes and penalty on income that may not actually be taxable. The IRS often will not get around to sending a notice until almost three years after the debt was compromised. The income needs to be reported on your tax return in the year of compromise and excluded as taxable if it is not taxable.

This legal area is a very complicated and has many exceptions. Please consult your tax advisor or a bankruptcy attorney to determine the potential impact of negotiating compromise of debt.