Cancellation of Debt Income
Cancellation of debt results if a debt for which the taxpayer is personally liable is discharged ("forgiven", or written off as uncollectible).
Reporting
IRC § 6050P requires certain financial institutions and federal agencies that cancel a debt of $600 or more during any calendar year to file information return Form 1099-C with the IRS and provide a copy to the taxpayer whose debt was cancelled.
Inclusion in income
Internal Revenue Code ("IRC") § 61(a)(12) provides that gross income includes “income from discharge of indebtedness” (i.e., the amount written off is taxable).
Gain of loss
The taxpayer may also realize gain or loss on the disposition as well as COD income if the debt is written off as a result of a foreclosure, sale, or other disposition of property that secures the debt, i.e., if the the fair market value ("FMV") exceeds taxpayer's basis.
Exceptions to inclusion in income, IRC § 108
IRC § 108 excludes discharges of indebtedness from gross income if:
- The discharge occurs in bankruptcy
- The discharge occurs when the taxpayer is insolvent
- The debt is “qualified farm indebtedness”
- The debt is a student loan for which the exclusion provided by IRC § 108(f) applies
Insolvency Exception
A taxpayer is insolvent to the extent that the taxpayer’s liabilities immediately before the discharge exceed the fair market value of the taxpayer’s assets immediately before the discharge. The amount excludable under the insolvency exception is limited to the amount by which the taxpayer is insolvent (the amount by which cancelled debt exceeds the amount taxpayer's net worth is negative is taxable).
The Mortgage Forgiveness Debt Relief Act of 2007
This Act generally allows taxpayers to exclude up to $2MM of ($1MM if married filing separately) of income from discharge of debt on their principal residence in calendar years 2007 through 2012. Debt reduced through mortgage restructuring and mortgage debt forgiven in connection with a foreclosure qualify for this relief. The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
The amount excluded reduces the taxpayer’s cost basis in the home.
information on http://www.IRS.gov
More details and detailed examples can also be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments http://www.irs.gov/pub/irs-pdf/p4681.pdf. Questions and answers based on the law prior to the passage of the Mortgage Forgiveness Debt Relief Act of 2007 are available at http://www.irs.gov/newsroom/article/0,,id=174034,00.html.
Information on the tax consequences of canceled debt is available in an audio podcast and a written transcript on http://www.irs.gov/businesses/small/article/0,,id=97726,00.html 
4/28/09
The IRS has a comprehensive new insolvency worksheet included in the newly revised edition of Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals), to determine whether and to what extent taxpayers are insolvent, and thus whether and to what extent their canceled debts are excluded from gross income. http://www.irs.gov/pub/irs-pdf/p4681.pdf 4/27/09