If you had debt cancelled and are no longer obligated to repay the debt, you generally must include the amount of cancelled debt in your income. However, if the discharge of indebtedness occurred while you were insolvent, the debt generally does not have to be added to your return as income. However, this exclusion does not apply to a discharge of indebtedness that occurred in a title 11 case or to any discharge of qualified principal residence indebtedness unless you elect to have the insolvency exclusion apply instead or the exclusion for qualified principal residence indebtedness.
What does it mean to be insolvent?
You were insolvent if your liabilities (the total amount of all debts) were more than the fair market value (FMV) of all of your assests immediately before the discharge. For more details on what it means to be insolvent, please reference IRS Publication 908, Bankruptcy Tax Guide.
What amount of cancelled debt can be excluded from income?
You can only exclude the amount of debt equal to the extent that you were insolvent.
Example: During the tax year, you were released from your obligation to pay back a credit card debt in the amount of $5,000. At the time of the discharge, the FMV of all of your assets totaled $7,000 and your total liabilities totaled $10,000. Therefore, you were insolvent to the extent of $3,000 ($10,000 in liabilities minus $7,000 in FMV of assets). In other words, your liabilities were $3,000 greater than your assets, so that is the extent that you were insolvent.
Because you were only insolvent to the extent of $3,000, you could only exclude $3,000 of your cancelled debt from income. The remaining $2,000 would have to be included in income unless you meet one of the other exclusions.
For more information, please review Publication 4681.