When Debt Disappears: The Tax Sting of Cancellation of Debt Income (and How to Defuse It)
By Cody C. Heimerdinger, CPA
You know the old saying: “Debt forgiven is income earned.” The IRS agrees. But like most things in the tax world, the truth depends on why and how that debt disappeared.
What Is Cancellation of Debt (COD) Income?
When a borrower’s obligation to repay money is canceled, forgiven, or discharged for less than the full amount owed, the IRS generally treats that “forgiveness” as taxable income under IRC §61(a)(12). In plain terms, if you owed $1 million and settled for $600,000, the $400,000 difference could be taxable COD income.
Why? Because your net worth just increased — you’re no longer on the hook for that $400,000, and the IRS considers that a form of economic gain.
When COD Income Doesn’t Apply
Not every forgiven debt leads to tax pain. The tax code and regulations carve out several important exceptions and exclusions, including:
- Bankruptcy Exclusion (§108(a)(1)(A)) – COD income discharged in a Title 11 bankruptcy case is excluded.
- Insolvency Exclusion (§108(a)(1)(B)) – If your liabilities exceed your assets at the time of discharge, COD income is excluded to the extent of insolvency.
- Qualified Real Property Business Indebtedness (QRPBI) – Allows certain taxpayers to exclude COD income tied to business real estate, with basis adjustments.
- Qualified Principal Residence Indebtedness (QPRI) – Temporary relief that excludes forgiven mortgage debt on a primary residence (though always check current legislative status).
- Purchase Price Adjustments (§108(e)(5)) – If a seller reduces a buyer’s purchase-money debt, it’s treated as a price adjustment — not income.
These exclusions often come with basis reductions or other trade-offs, so the relief is rarely “free.”
Special Situations: Partnerships and Related Parties
For partnerships and LLCs taxed as partnerships, COD issues can get tricky fast. A few key principles:
- The partnership itself generally recognizes COD income, which then flows through to the partners according to their ownership interests.
- When a partnership cancels a partner’s debt, the partner is treated as receiving a distribution equal to the forgiven amount (Treas. Reg. §1.731-1(c)(2)).
- If a related party or disregarded entity acquires the debt, the rules under §108(e)(4) may treat it as if the debtor bought back its own debt — potentially triggering COD income.
Careful structuring can make the difference between a taxable discharge and a clean, nonrecognition transaction.
Planning and Documentation Are Everything
Avoiding unwanted COD income is often less about luck and more about evidence. Before a transaction closes, confirm:
- The debtor’s solvency position;
- The fair market value and adjusted issue price of the debt;
- Whether any related-party or disregarded-entity rules apply; and
- That the proper valuation and documentation support any exclusion claim.
Well-drafted agreements and substantiated valuations can transform what looks like a taxable cancellation into a nonrecognition or excluded event.
The Takeaway
Debt relief might feel like financial freedom — until the IRS sends a thank-you note in the form of a tax bill. Understanding the mechanics of cancellation of debt income, and the exceptions that can eliminate or defer it, is crucial for anyone restructuring debt, settling loans, or planning entity liquidations.
Handled correctly, a debt’s disappearance doesn’t have to mean taxable income. It can simply mean a well-structured exit — and that’s the best kind of forgiveness there is.