12.1.1 Basic Principles

Generally, income from debt cancellation is includible in gross income.1  The amount of income is the difference between the face value of the debt and the amount paid in satisfaction of the debt. Income is recognized in the year the debt cancellation occurs.2  Debt cancellation often occurs in a foreclosure sale.3  Cancellation of a large debt may result in taxability of Social Security benefits for a low-income taxpayer or loss of Earned Income Credits.4

Typically, debt cancellation income arises when a lender forgives a debt or a government entity waives an overpayment. Examples of potential debt cancellation income include reduction or forgiveness of personal credit card debt or loans,5  personal vehicle repossession, loan workout agreement or modification, mortgage foreclosure, quit claim or reconveyance to creditor, short sale, abandonment,6  Truth-in-Lending rescissions,7  and government waiver of overpayment by the government.8

• 1I.R.C. § 61(a)(12).
• 2Rood v. Comm’r, T.C. Memo 1996-248, aff’d, 122 F.3d 1078 (11th Cir. 1997); Jelle v. Comm’r, 116 T.C. 63 (2001).
• 3If local law provides a right to redeem a foreclosure sale, the sale is generally not final for tax purposes until the right to redeem expires. Great Plains Gasification Assocs. v. Comm’r, T.C. Memo 2006-276.
• 4Jelle, 116 T.C. at 70–71 (2001); Payne v. Comm’r, T.C. Memo 2008-66, n.3.
• 5The Tax Court has ruled that a reduced payment in settlement of a credit card debt constitutes debt cancellation income. Payne, T.C. Memo 2008-66 (purchase price adjustment exclusion denied); Plotinsky v. Comm’r, T.C. Memo 2008-244 (gift exclusion denied). Because no exclusions applied in Payne and Plotinsky, the write-off of the credit card debt was income to the taxpayer. See also Hill v. Comm’r, T.C. Memo 2009-101 (debt cancellation income where credit card judgment and debt written off after Ch. 13 bankruptcy dismissed).
• 6Frazier v. Comm’r, 111 T.C. 243 (1998).
• 7Schlifke v. Comm’r, T.C. Memo 1991-19.
• 8See, e.g., Waterhouse v. Comm’r, T.C. Memo 1994-467 (waiver of VA overpayment creates debt cancellation income). On the other hand, the IRS has privately ruled that the VA’s discharge of a veteran’s mortgage due to hardship was not taxable when the VA intended to reduce the veteran’s future benefits for the amount of the debt forgiveness. Priv. Ltr. Rul. 8839026 (June 29, 1988). Also, cancellation or waiver of an overpayment due to economic hardship should be excluded from income under the general welfare exclusion doctrine. See, e.g., Rev. Rul. 78-46, 1978-1 C.B. 22.