Do not include a canceled debt in gross income if any of the following situations apply:
- The cancellation takes place in a bankruptcy case under the U.S. Bankruptcy Code. See Bankruptcy case exclusion, later.
- The cancellation takes place when you are insolvent (see Insolvency exclusion, later), and the amount excluded is not more than the amount by which you are insolvent.
- The canceled debt is qualified farm debt (debt incurred in operating a farm). See chapter 4 of Publication 225, Farmer’s Tax Guide.
- The canceled debt is qualified real property business indebtedness (certain debt connected with business real property). See Publication 525, Taxable and Nontaxable Income.
Order of exclusions. If the cancellation of debt occurs in a title 11 bankruptcy case, the bankruptcy exclusion takes precedence over the insolvency, qualified farm debt, or qualified real property business indebtedness exclusions.
To the extent that the taxpayer is insolvent, the insolvency exclusion takes precedence over qualified farm debt or qualified real property business indebtedness exclusions.
Bankruptcy case exclusion. A bankruptcy case is a case under title 11 of the United States Code, but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.
None of the debt canceled in a bankruptcy case is included in your gross income in the year canceled. Instead, certain losses, credits, and basis of property must be reduced by the amount of excluded income (but not below zero). These losses, credits, and basis in property are called tax attributes and are discussed under Reduction of Tax Attributes, later.
Insolvency exclusion. You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. Determine your liabilities and the fair market value of your assets immediately before the cancellation of your debt to determine whether or not you are insolvent and the amount by which you are insolvent.
Exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are insolvent. However, you must use the amount excluded to reduce certain tax attributes, as explained later under Reduction of Tax Attributes.
Example. $4,000 of the Simpson Corporation’s liabilities are cancelled outside bankruptcy. Immediately before the cancellation, the Simpson Corporation’s liabilities totaled $21,000 and the fair market value of its assets was $17,500. Because its liabilities were more than its assets, it was insolvent. The amount of the insolvency was $3,500 ($21,000 –$17,500).
The corporation may exclude only $3,500 of the $4,000 debt cancellation from income because that is the amount by which it was insolvent. It must also reduce certain tax attributes by the $3,500 of excluded income. The remaining $500 of canceled debt must be included in income.