Did you know that forgiven debts are considered income by the IRS? Because they are classified as income, they are also taxable. This means that a debt of $10,000 that has been ‘forgiven’ is considered to be unearned income and so subject to taxation. The IRS put it very simply:

If you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable.

As you look around the internet at information related to bankruptcy, you may be confused as to whether or not debt forgiven through bankruptcy is taxable or not. I have read articles that claim that all debt cancelled through bankruptcy is taxable while others claim that no tax is due at  all. Others make various exceptions in a fence-sitting type exercise.

Rather that try and second guess what is fact and what is fiction – let’s put the whole issue to bed. From the IRSs perspective, the situation is very clear and has no exceptions. In response to the question – Is Cancellation of Debt income always taxable? – the IRS has the following to say:

Not always – The most common situations when cancellation of debt income is not taxable involve:

• Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.

That is a very clear response – debts discharged through bankruptcy are NOT considered income or subject to income tax.

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