Income and Assets · Income

Tax treatment of forgiveness of debt

Debt that goes away is income. Discharge of indebtedness is enumerated in the definition of gross income (IRC § 61(a)(11)), and everything a taxpayer can do about it is an exception in a named section. For 2026 two of the exceptions clients had come to rely on have closed within months of each other, which makes this a topic where advice given eighteen months ago is now positively harmful.

The rule

Five exclusions, in a fixed order of precedence. Gross income does not include discharge income where the discharge occurs in a title 11 case, occurs while the taxpayer is insolvent, or is of qualified farm indebtedness, qualified real property business indebtedness for a taxpayer other than a C corporation, or qualified principal residence indebtedness — the last reaching only a discharge before 1 January 2026, or one under an arrangement entered into and evidenced in writing before that date (IRC § 108(a)(1)(A)–(E)). The title 11 exclusion displaces the other four (IRC § 108(a)(2)(A)), and insolvency displaces the farm and real property business exclusions (IRC § 108(a)(2)(B)).

Insolvency is measured, and it caps the exclusion. “Insolvent” means the excess of liabilities over the fair market value of assets, determined immediately before the discharge (IRC § 108(d)(3)), and the amount excluded cannot exceed the amount by which the taxpayer is insolvent (IRC § 108(a)(3)). A taxpayer who is insolvent by less than the discharge therefore has income for the difference.

Exclusion is deferral, not forgiveness. An amount excluded under the title 11, insolvency or qualified farm exclusions reduces the taxpayer’s tax attributes in a statutory order (IRC § 108(b)(1), (2)), one dollar of attribute for each dollar excluded — except that the three credit carryovers are reduced at 33⅓ cents per dollar (IRC § 108(b)(3)(A), (B)). The taxpayer may elect to apply the reduction first against the basis of depreciable property, capped at the aggregate adjusted bases held at the start of the following year, in which case the ordinary order does not apply (IRC § 108(b)(5)). Basis reductions are made under § 1017.

Recourse and nonrecourse are different transactions. On a disposition, the amount realized includes liabilities from which the transferor is discharged (Reg. § 1.1001-2(a)(1)) — but where the liability is recourse, the amount realized does not include amounts that are discharge of indebtedness income (Reg. § 1.1001-2(a)(2)). So a recourse foreclosure splits into two computations: gain or loss measured against the property’s fair market value, and separately discharge income for any deficiency forgiven. A nonrecourse foreclosure does not split: the sale or other disposition of property securing a nonrecourse liability discharges the transferor from that liability (Reg. § 1.1001-2(a)(4)(i)), so the entire outstanding balance is amount realized and there is no discharge income at all.

Student loan relief has narrowed sharply. Discharge of a student loan under a provision requiring work for a period in certain professions for a broad class of employers remains excluded (IRC § 108(f)(1)). Beyond that, IRC § 108(f)(5) now reaches only discharges on death or total and permanent disability, and requires the taxpayer’s social security number on the return (IRC § 108(f)(5)(A), (C)). Pub. L. 119-21 § 70119(c) applies the change to discharges after 31 December 2025.

Reporting is unchanged and low. An applicable entity discharging indebtedness must file an information return, with an exception only for a discharge below the small figure in the table below (IRC § 6050P(a), (b)).

Current figures

How it works in practice

Work the questions in the order the statute does. Is there discharge income at all — which for a secured debt means asking recourse or nonrecourse before anything else? If so, does an exclusion apply, and which one takes precedence? If an exclusion applies, what attributes are reduced?

The recourse question is the one clients cannot answer and the loan documents can. It is also the one that changes the character of the tax: a recourse foreclosure can produce capital gain and ordinary discharge income from a single event, while a nonrecourse foreclosure produces only gain or loss. Neither outcome is intuitively better — a nonrecourse disposition can generate a large gain on a property the client thinks they lost.

Insolvency is the exclusion most often available and most often mis-measured. It is a balance-sheet test taken immediately before the discharge, and it includes assets clients do not think of as assets — retirement accounts, cash values, and property that is exempt from creditors. Building the schedule is the work; the answer follows from it.

Say plainly that the insolvency and title 11 exclusions cost something later. Attribute reduction takes away losses and basis the client would otherwise have used, so the exclusion converts a present tax into a future one. Where the taxpayer has substantial depreciable property, the § 108(b)(5) election is worth modelling rather than defaulting past.

Finally, check the date. A discharge of home mortgage debt in 2026 is outside § 108(a)(1)(E) unless the written arrangement predates the year, and a student loan discharge in 2026 is outside § 108(f)(5) unless it is on death or total and permanent disability. Both were available on very different terms in 2025, and clients will have been told so.

How this has changed

Two exclusions closed for 2026, and they closed independently.

IRC § 108(a)(1)(E) was last extended by Pub. L. 116-260 § 114(a), which substituted 1 January 2026 for 1 January 2021 in both places. It was not extended again. An ordinary 2026 discharge of home mortgage debt is therefore includible unless the title 11 or insolvency exclusion reaches it.

IRC § 108(f)(5) has now been rewritten twice in five years, and the second rewrite undoes the first. Pub. L. 117-2 § 9675 replaced the death-and-disability rule with a broad exclusion for any student loan discharge in 2021 through 2025. Pub. L. 119-21 § 70119 amended the paragraph generally, restoring the death and total and permanent disability rule and adding a social security number requirement, for discharges after 31 December 2025. The sequence matters for reading older material: a source written between 2021 and 2025 describes a rule that has been withdrawn, and a source written before 2021 describes, almost exactly, the rule that is back.

One figure did not move. Pub. L. 119-21 § 70433 more than tripled the general information reporting threshold in IRC § 6041(a) and indexed it, and made parallel changes elsewhere — but it did not touch IRC § 6050P(b), which still excepts only a discharge below its own much smaller figure, unamended since 1999. So a client may now receive a Form 1099-C for an amount too small to generate a Form 1099-MISC. Assuming a single uniform reporting threshold across 2026 is a mistake.

Exam focus

The first question is always recourse or nonrecourse, and the examinable consequence is that nonrecourse produces no discharge income while putting the whole liability into amount realized. Expect facts where the property’s value differs from the debt and the answer turns on which regime applies.

Know the five exclusions and the two precedence rules, and know that insolvency is capped at the amount of insolvency measured immediately before the discharge.

Know that exclusion triggers attribute reduction, the order of the attributes, and the 33⅓ cent rate for credit carryovers.

For 2026, expect the two closures to be tested as timing questions — a discharge either side of 31 December 2025 — rather than as questions about the exclusions themselves.

Check yourself

1. A taxpayer’s property secures a nonrecourse debt of $180,000 and has an adjusted basis of $120,000. The lender forecloses when the property is worth $150,000. What are the consequences?

Answer: $60,000 of gain and no discharge of indebtedness income. Reg. § 1.1001-2(a)(4)(i) treats the disposition of property securing a nonrecourse liability as discharging the transferor from it, and Reg. § 1.1001-2(a)(1) includes the full liability in the amount realized — so $180,000 less the $120,000 basis. The property’s $150,000 value is irrelevant to the computation.

2. A taxpayer with liabilities of $400,000 and assets worth $370,000 immediately before a discharge has $50,000 of debt forgiven outside bankruptcy. How much is excluded?

Answer: $30,000. IRC § 108(d)(3) measures insolvency as the excess of liabilities over the fair market value of assets immediately before the discharge, which is $30,000, and IRC § 108(a)(3) caps the exclusion at that amount. The remaining $20,000 is includible, and the excluded $30,000 reduces tax attributes under IRC § 108(b)(2).

3. A federal student loan balance is forgiven in February 2026 at the end of an income-driven repayment plan. Is it excluded?

Answer: no. The broad exclusion for any student loan discharge applied to discharges in 2021 through 2025; Pub. L. 119-21 § 70119 amended IRC § 108(f)(5) generally, and § 70119(c) applies the amendment to discharges after 31 December 2025. What remains is death or total and permanent disability under § 108(f)(5), and work-in-profession forgiveness under § 108(f)(1). Neither reaches an income-driven repayment discharge, so the general § 108(a) exclusions are the only route.

4. A taxpayer excludes $90,000 under the insolvency exclusion and holds a general business credit carryover. By how much is that carryover reduced?

Answer: by 33⅓ cents for each dollar excluded that reaches it. IRC § 108(b)(3)(A) sets the general rate at a dollar per dollar, but § 108(b)(3)(B) applies 33⅓ cents per dollar to the reductions in subparagraphs (B), (C) and (G) of § 108(b)(2) — the general business credit, minimum tax credit and foreign tax credit carryovers. The order in § 108(b)(2) still governs which attributes are reached first, net operating losses coming before the credit.