Debt cancellation can help a beleaguered borrower survive but it also can trigger negative tax consequences. Cancellation of Debt (COD) Income Is Taxable. When a lender forgives part or all your debt, it results in “Cancellation of Debt (COD) Income. “

Although the general federal income tax rule is that COD Income counts as gross income that must be reported on your federal income tax return for the year in which the debt cancellation occurs, there are several exceptions to the general rule that COD income is taxable. Here are three of them:

Insolvency Exception
When an insolvent borrower (as opposed to a bankrupt borrower) has COD income, it’s excluded from gross income to the extent of the borrower’s insolvency immediately before the COD transaction.

Bankruptcy Exception
COD income from debt cancellations that are granted in Title 11 bankruptcy proceedings are automatically excluded from the borrower’s gross income but certain tax attributes may need to be reduced. This takes precedence over the Insolvency Exception. When debt cancellation occurs in bankruptcy proceedings, the bankruptcy exception rules must be followed.

Exempt Assets
Some personal assets are generally off-limits for creditors. Unfortunately, the Tax Court has agreed with the IRS position that exempt assets should be included as assets in the insolvency calculation.

The decision to cancel your debt should not be undertaken lightly but should be carefully considered and planned with your Tax Specialist and those who will be affected.