One of the most counterintuitive rules in tax law is that when a debt is forgiven, the debtor often owes income tax on the amount forgiven. How can having a debt cancelled be a taxable event? The Supreme Court answered that question in 1931 in United States v. Kirby Lumber Co., 284 U.S. 1, and the principle has been refined ever since – though Congress has created several exceptions for insolvent and bankrupt taxpayers.
The Kirby Lumber Principle
In 1923, Kirby Lumber issued bonds for $12,126,800. Later that year, it bought back some of its own bonds on the open market for less than par – saving $137,521.30. The Supreme Court held that the company had realized taxable income.
Justice Holmes, writing for a unanimous Court, explained: “As a result of its dealings, it made available $137,521.30 assets previously offset by the obligation of bonds now extinct.” The company was better off by that amount, even though it never received cash from the bond buyback. The “freeing of assets” was enough.
The Insolvency Exception – Judicial Origins
Kirby Lumber involved a solvent company. What if the debtor is insolvent – debts exceed assets – before the cancellation? Lower courts struggled with this. In Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95 (5th Cir. 1934), the court held that cancellation of debt (COD) income was not recognized when the debtor remained insolvent after cancellation because “nothing of exchangeable value comes to or is received by the taxpayer.” The debt was never going to be paid anyway; cancellation didn’t free any assets.
But in Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289 (1937), the court held that COD income was realized when cancellation made the debtor solvent (assets exceeded liabilities). The debtor received an “increment to its assets clear and free of any claims.”
These cases established the “insolvency exception” to COD income: COD income is recognized only to the extent the debtor becomes solvent after the cancellation.
The Codification – Section 108
In 1954, Congress codified the insolvency exception and added a bankruptcy exception. Current Section 108(a)(1)(A) and (B) provide that COD income is excluded from gross income if the discharge occurs in a Title 11 bankruptcy case or when the taxpayer is insolvent (but only up to the amount of insolvency).
But Congress didn’t make the exclusion tax-free forever. Instead, Section 108(b) requires the taxpayer to reduce tax attributes (net operating losses, credit carryovers, basis in property, etc.) by the amount of excluded COD income. The idea is to defer – not permanently exempt – the tax.
The “Reduction of Tax Attributes” Mechanism
When a taxpayer excludes COD income under Section 108(a), the excluded amount must be applied to reduce certain tax attributes in the following order (Section 108(b)(2)):
- Net operating losses (NOLs)
- General business credits
- Minimum tax credits
- Capital loss carryovers
- Basis in property (but not below zero)
- Passive activity loss and credit carryovers
- Foreign tax credit carryovers
For most individual taxpayers, the basis reduction is the most significant. Reducing basis in property increases future gain when the property is sold – effectively deferring the tax until that sale.
Purchase Money Debt Reduction – Section 108(e)(5)
There’s a special rule for purchase money debt. If a buyer owes the seller a debt arising from the purchase, and the seller reduces that debt, the reduction is treated as a purchase price adjustment, not COD income. This prevents the strange result of having income when the seller simply agrees to lower the price after the sale.
But Section 108(e)(5) applies only when the debt reduction occurs between the original buyer and seller. If the debt has been transferred to a third party (e.g., a bank), any debt reduction by that third party is COD income, not a purchase price adjustment. The court applied this rule in Preslar v. Commissioner, 167 F.3d 1323 (10th Cir. 1999), where a bank (not the seller) reduced the debt – resulting in COD income.
The Contested Liability Doctrine
What if the amount of the debt itself is disputed? The “contested liability doctrine” (or “disputed debt doctrine”) holds that if a taxpayer in good faith disputes the original amount of a debt, a subsequent settlement fixes the amount of the debt for tax purposes – the debtor doesn’t realize COD income on the difference between the original claim and the settlement amount.
The leading case is Zarin v. Commissioner, 916 F.2d 110 (3d Cir. 1990), where a compulsive gambler owed a casino over $3.4 million but settled for $500,000 because the casino had ignored regulatory orders to stop extending credit. The Third Circuit held the debt was unenforceable under New Jersey law, and the settlement fixed the amount – no COD income.
The Preslar court criticized Zarin, noting a difference between disputing the amount of a liquidated debt (where the amount is fixed but liability is contested) and disputing an unliquidated amount. The doctrine applies only when the amount (not just the liability) is genuinely in dispute.
Qualified Principal Residence Indebtedness
In response to the 2008 financial crisis, Congress added Section 108(a)(1)(E), excluding COD income from discharge of qualified principal residence indebtedness (up to $750,000). This provision, extended several times, currently applies to discharges through December 31, 2025. The discharge reduces the taxpayer’s basis in the home, but not below zero.
Student Loan Forgiveness
Section 108(f)(1) provides an exclusion for student loan forgiveness if the discharge is conditioned on the borrower working for a certain period in certain professions (medicine, nursing, teaching, etc.) for a broad class of employers. The Tax Cuts and Jobs Act added Section 108(f)(5), which excludes from gross income student loan forgiveness due to death or disability (effective for discharges after 2017).
The CARES Act and subsequent legislation temporarily expanded student loan forgiveness exclusions for certain COVID-related programs.
Why Should COD Income Be Taxable at All?
The “transactional approach” asks whether the taxpayer received a tax benefit from the loan in the first place. If loan proceeds were used to purchase an asset that has since declined in value, perhaps the cancellation merely reflects that decline – not new wealth.
But the Supreme Court has consistently rejected that approach. In Kirby Lumber, the Court focused on the “making available” of assets. In Commissioner v. Tufts, 461 U.S. 300 (1983), the Court held that nonrecourse debt must be included in the amount realized on sale, even if the property’s value is less than the debt. The debt is treated as true debt from inception, and its extinguishments produce income.
The Kirby Lumber principle remains the foundation: when a debt is forgiven, the debtor has been enriched. The enrichment may be offset by other losses, but the annual accounting system requires that enrichment to be recognized in the year of forgiveness – unless Congress provides an exception. And Congress has provided several, for those who truly need a fresh start.
Disclaimer: This article provides general information for educational purposes only and does not constitute legal advice. Tax laws, judicial interpretations, and IRS guidance are subject to change at any time through legislation, regulation, or court decision. Readers should consult Alan Goldstein & Associates for advice regarding their specific factual situations.
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