Cancellation of Debt
  • January 19, 2021
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Most taxpayers believe that the IRS only charges taxes on income from a regular job or business, stock sale, or sale of an asset, however, it may also levy income tax on canceled tax. According to tax rules specified by the IRS, if a taxpayer’s debt is canceled, discharged, or forgiven, they must include the canceled amount in their gross income and pay taxes on it unless they qualify for an exemption or exclusion. In case they haven’t paid taxes on the canceled debt and have received notice from the IRS, they must immediately seek IRS tax help from an experienced IRS lawyer who can either negotiate an IRS installment agreement or help them qualify for an exclusion. Continuing on the topic, in this blog post, we discuss all you need to know about IRS canceled debt. Read on!

Qualifying for an Exclusion on Debt Canceled due to Insolvency

The IRS will exclude a taxpayer’s canceled debt if the discharge occurs for a bankruptcy case or if the taxpayer is qualified for principal residence indebtedness, farm indebtedness, real property business indebtedness, and insolvent taxpayers to the extent they are insolvent. If you qualify for an exclusion on debt canceled due to insolvency, seek assistance from an experienced Dallas tax attorney who can present your case in front of an IRS professional and help you get tax exemption.

Related Blog: 5 IRS Debt Relief Provisions That Offer Solace To Financially-Distressed Taxpayers

Filing an Exclusion for the Cancellation of Debt Due to Insolvency

While applying for an insolvency exclusion, taxpayers must fill a form that includes details about their liabilities and assets. The Internal Revenue Service allows taxpayers to exclude canceled debt if their liabilities exceed their assets. For instance, if a taxpayer has $20,000 in liabilities and $17,000 in assets, they can exclude the difference as they qualify for forgiveness for up to $3,000 in canceled debt. The tax on $3,000 could be up to almost $1,200 and taxpayers can hire a tax attorney to claim an exclusion and generate more tax returns.

Filing an Exclusion for Principal Residence Indebtedness

Taxpayers who qualify for principal residence indebtedness can also get exclusion from canceled debt. A qualified principal residence is a taxpayer’s “primary home” in which they live most of the time. This type of cancellation occurs when the lender starts a foreclosure action or agrees to a short sale. Until 2016, the IRS allowed an exclusion of up to $2,000,000 in canceled mortgage debt arising from short sales and foreclosure of taxpayers’ primary residences. This exclusion forced the majority of taxpayers into foreclosure or short sales to prevent the double penalty of a tax bill for unpaid mortgage debt. After 2016, the IRS started allowing exclusion if the discharge was “subject to an arrangement that was entered into and evidenced in writing before January 1, 2018”.

Cancelled Debt is Taxable

According to the IRS, if a taxpayer’s tax debt is forgiven, discharged, or canceled, the amount will be counted as taxable income. Please note that if the taxpayer has borrowed a loan, it will not be considered as an income and its repayment will not be added in deductions, but if the lender cancels the debt, the IRS will treat the amount as taxable income.

Related Blog: IRS Debt Relief: Do’s and Don’ts


Paying tax on canceled debt is one of the harshest provisions in the IRS system as it punishes taxpayers who are already struggling. There can be some exemptions to the rule. If canceled credit card debt is from a bankruptcy and if the taxpayer can prove that they owed more total debt than the value of their assets at the time of the forgiveness, they may get exemption on the canceled debt.

Wrap Up

Understanding the concept of taxation on canceled debt may be tricky, which is why you must seek assistance from an experienced Dallas tax attorney. They can help you qualify for exemptions or enter into an IRS installment agreement so that you do not enter into a financial crisis while paying back taxes. To get help on issues such as in an IRS installment agreement, look no further than the Law Offices of Nick Nemeth’s team of seasoned IRS tax attorneys in Dallas/Fort Worth. Simply call (972) 426-2553 or fill out our contact form, and we will take it from there.

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