If a taxpayer borrows money, the borrowed funds are not included in the taxpayer’s gross income. That treatment is proper even though the taxpayer has increased his assets by the amount he borrowed since he has also has created a corresponding liability to pay back the loan. The taxpayer’s net wealth has not increased. The more difficult and interesting questions arise when the taxpayer fails to repay the loan. At first blush, it would appear that upon cancellation of a loan, the taxpayer should have income for the amount that was canceled. However, the current tax treatment that simple. A number of exceptions exist to the straightforward treatment under which the cancellation requires the taxpayer to recognize income. Some of those exceptions reflect an application of normal tax principles while others exist for programmatic purposes. Those exceptions make the tax treatment of cancellation of debt particularly complex.
The goal of this Article is to set out the tax treatment of cancellation of debt, including the many exceptions that apply. It reviews the history of the cancellation of debt rules which help explain how we arrived at the current treatment. It covers the current statutory treatment of cancellation of debt as well as the many common law rules (such as the transactional approach and the tax benefit rule) that apply.