When a lender forgives a debt - through foreclosure, short sale, debt settlement, or bankruptcy discharge - the cancelled amount is generally income to the borrower under IRC §61(a)(11). This surprises many taxpayers who receive a Form 1099-C and assume the IRS is making an error. The income is real. However, IRC §108(a)(1) provides five specific exclusions that can eliminate or defer all or part of the COD income. Understanding which exclusion applies - and what tax attributes must be reduced in exchange - is essential before filing.
Gross income includes income from the discharge of indebtedness. When a lender forgives $50,000 of debt, the borrower has $50,000 of gross income - taxable at ordinary rates - unless one of the §108 exclusions applies. The amount is reported to the borrower on Form 1099-C and must be addressed on the return even if the taxpayer believes an exclusion applies.
| Exclusion | Applies When | Attribute Reduction Required |
|---|---|---|
| Bankruptcy | Debt discharged in a Title 11 bankruptcy case | Yes - tax attributes reduced in order (NOLs, credits, basis, passive losses, foreign tax credit carryforwards) |
| Insolvency | Taxpayer is insolvent immediately before the discharge (liabilities exceed FMV of assets) | Yes - limited to the amount of insolvency; excess COD is taxable. Attribute reduction required on amount excluded. |
| Qualified farm debt | Debt incurred directly in the operation of a farm by a qualified person | Yes - same ordering rules |
| Qualified real property business indebtedness (QRPBI) | Debt secured by real property used in a trade or business; election by non-C-corp taxpayer | Yes - basis of depreciable real property reduced (§108(c)(1)); other attributes are not reduced |
| Qualified principal residence indebtedness (QPRI) | Debt discharged on principal residence - excluded only if discharged before January 1, 2026, or under a written arrangement entered into before January 1, 2026 (§108(a)(1)(E)); limited to $750,000 ($375,000 MFS) of acquisition debt (§108(h)(2)) | No §108(b) attribute reduction - basis of the principal residence is reduced, not below zero (§108(h)(1)) |
| Purchase price reduction | Seller reduces purchase-money debt on property sold on credit when the buyer is not insolvent and not in a title 11 case (§108(e)(5)) - treated as a purchase price adjustment, not income | Buyer reduces basis in the property |
Insolvency is measured immediately before the discharge event. Total liabilities (including the cancelled debt) are compared to the fair market value of all assets (including retirement accounts, home equity, cars, investments). If liabilities exceed assets, the taxpayer is insolvent to that extent.
Example: Taxpayer has $300,000 of liabilities and $200,000 of assets immediately before a $80,000 debt is cancelled. Insolvency = $100,000 ($300K - $200K). COD income = $80,000. Since COD ($80K) does not exceed insolvency ($100K), the entire $80,000 is excluded from income. If the COD were $120,000, only $100,000 would be excluded and $20,000 would be taxable.
Most §108 exclusions are not free - in exchange for excluding COD income now, the taxpayer must reduce their tax attributes. This means the tax is deferred, not permanently eliminated. The required reduction order under IRC §108(b):
The taxpayer can elect under IRC §108(b)(5) to apply the attribute reduction to basis in depreciable property first, before reducing NOLs. This is often beneficial because it avoids losing an NOL carryforward that might be used at a higher tax rate than the basis reduction would cost in future depreciation.
Lenders are required to issue Form 1099-C when they discharge $600 or more of debt. The form reports the amount discharged, the date, and the fair market value of property (if applicable). Receiving a Form 1099-C does not automatically mean you owe tax - it means the lender reported a discharge, and you must address it on your return. File Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) to claim any applicable exclusion and report the required attribute reduction.