In some cases, you may be able to avoid taxes on forgiven debt. This is generally true if you are insolvent or if the debt is discharged as part of a bankruptcy proceeding.
Insolvency
You are insolvent if your debts are greater than your assets. If you are insolvent, you may be able to exclude the forgiven debt from your income. However, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your tax return.
Bankruptcy
If your debt is discharged as part of a bankruptcy proceeding, you may also be able to exclude the forgiven debt from your income. However, you must file Form 982 with your tax return.
Exceptions
There are some exceptions to the rules for excluding forgiven debt from your income. For example, you cannot exclude forgiven debt if it is:
A loan from a qualified retirement plan
A student loan
A loan from a governmental agency
Tax Consequences of Forgiven Debt
If you are unable to exclude forgiven debt from your income, you will have to pay taxes on the amount of the debt that is forgiven. The amount of tax you owe will depend on your tax bracket.
Seek Professional Advice
If you have forgiven debt, it is important to seek professional advice from a tax advisor or accountant to determine if you can exclude the debt from your income.