This paper discusses the tax effects of cancellation of debt. Whenever a taxpayer, who had incurred a financial obligation, is relieved of liability, in whole or in part, the discharge of indebtedness income doctrine is applicable. At this point, the taxpayer recognizes income “equal to the difference between the initial obligation and the amount, if any, paid to discharge that obligation.” Smith v. Commissioner, 198 F.3d 515, 530 (5th Cir. 1999).
The cancellation of indebtedness may include situations where a debtor performs a service for a creditor, who in turn cancels the debt, then the debtor realizes as gross income the amount of the debt as compensation for the services. In addition, income may be realized by the payment or purchase of obligations at less than their face value.
The paper discusses in detail the contested liability exception to the discharge of indebtedness income doctrine, as well as the purchase price adjustment exception. Also discussed are exceptions found in § 108(a)(1) of the Internal Revenue Code which include bankruptcy, insolvency, qualified farm indebtedness, and qualified real property business indebtedness.
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