The United States is awash in a sea of debt. In the midst of the most severe recession since the Great Depression, loan delinquencies and charge-offs are at levels heretofore unknown in the modern financial era. Every loan charge-off and mortgage foreclosure has tax consequences. While the creditor most often claims a bad debt deduction or business related loss, the debtor generally must recognize gross income and pay income taxes on an amount roughly equal to the creditor’s loss, unless a special exception applies to exclude the debt relief from income. This article deals with the tax consequences to the debtor of the discharge of a debt for less than full payment. It first explain the origins and rationale for the rule, now codified in § 61(a)(12), that requires the inclusion of '[i]ncome from discharge of indebtedness.' The article then examines the various events that trigger recognition of income under § 61(a)(12). Following that discussion, the article deals with the manner in which the amount of income from discharge of indebtedness is computed. This part of the article also discusses the tax consequences to a business entity that issues an equity interests to a creditor to satisfy a debt. Finally, the article explores the myriad of statutory rules in §108 that permit nonrecognition income from discharge of indebtedness under particular circumstances, and the various ancillary consequences that follow from nonrecognition. Throughout, the article explores the relationship of income from discharge of indebtedness to realization of gain from the transfer of property to satisfy a debt by contrasting the tax consequences of transfers of property to discharge a debt with the consequences of discharge of a debt for less than full payment.
Martin J. McMahon & Daniel L. Simmons, A Field Guide to Cancellation of Debt Income, 63 Tax Law. 415 (2010), available at http://scholarship.law.ufl.edu/facultypub/623