“Discharge of indebtedness” occurs when someone seeks and gets relief from their creditors by asking the creditors to accept less than the amount they are owed. The Internal Revenue Service believes that since you, the borrower, have paid less than you owe, what you save is a form of income. Given that, it is taxable as income.
In 1926 the United States Supreme Court, in the case of Bowers vs. Kerbaugh-Empire, determined that when a borrower makes terms with a lender to repay less than what they owe them, the borrower has increased his or her net worth. In the specific case of Bowers vs. Kerbaugh-Empire, the borrower had received loans that they ultimately only had to repay a fraction of. The Supreme Court reasoned that the “free money” the borrower (in this case a company) received, added to their gross income and so was taxable.
This law was and is considered somewhat controversial, and many people familiar with tax laws take legal issue with it. Nevertheless, the law still stands. So, the difference between the debt and the value of the asset used to pay off the debt at the reduced rate needs to be included in the borrower’s gross income. If you, the borrower, used a non-cash asset, such as a house or car to pay off your debt, then you may have to pay capital gains tax on the asset if it had appreciated in value.
Income from discharge of indebtedness is complicated to evaluate, with the rules and regulations surrounding it numerous and open to much interpretation. It’s a two-step process. First, it needs to be determined that gross income from the asset exists, and then whether or not any amount of that can be excluded according to various tax codes.
If you need to know more about income from discharge of indebtedness, be sure to sit down with a tax attorney, a bank representative or a financial advisor and go over everything in as much detail as you need in order to understand it all.