Cancellation of debt, also known as debt forgiveness, occurs when a lender agrees to forgive or cancel all or a portion of a borrower’s outstanding debt. Under the Internal Revenue Code (IRC) Section 61, canceled debt is considered income and is typically subject to income tax. However, certain exceptions and exclusions to this rule may apply in certain circumstances.

One exception to the general rule is provided under IRC Section 108, which deals with the exclusion of discharge of qualified principal residence indebtedness. This section applies to debt that is discharged between January 1, 2007 and December 31, 2017, and the debt must be discharged in connection with the sale of the taxpayer’s principal residence. The debt must also be used to acquire, construct, or substantially improve the principal residence and must be secured by the residence. If these conditions are met, the taxpayer may exclude up to $2 million ($1 million for married individuals filing separately) of the discharged debt from income.

Another exception is provided under IRC Section 1017, which deals with the exclusion of discharge of indebtedness income in a Title 11 case. This section applies to debt discharged in a case under Title 11 of the United States Code (commonly known as bankruptcy) and the debtor must be an individual. The taxpayer may exclude the discharged debt from income if the court grants the discharge in the case.

Additionally, IRC Section 108(a)(1)(E) provides an exclusion for discharge of qualified farm indebtedness, for a taxpayer who is an individual, and the debt must be discharged in a Title 11 case.

Another exclusion from income is provided under IRC Section 108(b)(1) which deals with the exclusion of discharge of indebtedness income in a Title 11 case. This section applies to debt discharged in a case under Title 11 of the United States Code (commonly known as bankruptcy) and the debtor must be a corporation or partnership. The taxpayer may exclude the discharged debt from income if the court grants the discharge in the case.

It is also important to note that in certain situations, the cancellation of debt may have other tax implications. For example, suppose the borrower has a mortgage on a rental property and the lender forgives a portion of the mortgage. In that case, the borrower may have to recognize the cancellation of debt income, but may also be able to claim a loss on the rental property due to the reduction in the mortgage.

In conclusion, Cancellation of debt, also known as debt forgiveness, occurs when a lender agrees to forgive or cancel all or a portion of a borrower’s outstanding debt. Under the Internal Revenue Code (IRC) Section 61, canceled debt is considered income and is typically subject to income tax. However, certain exceptions and exclusions to this rule may apply in certain circumstances. For example, IRC Section 108 excludes the discharge of qualified principal residence indebtedness, and IRC Section 1017 excludes the discharge of indebtedness income in a Title 11 case. Additionally, IRC Section 108(a)(1)(E) provides an exclusion for discharge of qualified farm indebtedness, for a taxpayer who is an individual, and the debt must be discharged in a Title 11 case. IRC Section 108(b)(1) also provides an exclusion for discharge of indebtedness income in a Title 11 case. It applies to debt discharged in a case under Title 11 of the United States Code (commonly known as bankruptcy) and the debtor must be a corporation or partnership.

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