The economy is in the tank, and folks are not in a position to pay their debts as they once were. As a result, people are letting their homes and other real estate assets go into foreclosure. They are also seeking the protection of the bankruptcy courts to end the constant calls from their creditors. In the end, these decisions are enabling many people to get on with their lives. The last step in these difficult decisions is a consideration of the income tax consequences. When debt is forgiven by a lender or discharged in a bankruptcy, there is potentially taxable income that must be reported for federal income tax purposes. The resulting tax liability can be as onerous as the original debt. So careful consideration of the tax consequences in this situation is very important.

The good news is that there are lots of exceptions to the normal rule that the amount of debt forgiven be included as taxable income. Generally, the cost of these exceptions is that the taxpayer must reduce his, her or its tax attributes (credits, losses and the like) as well as tax basis in remaining assets. What this does is basically put off the tax liability until these other assets are ultimately sold (with a reduced basis).

The most common areas that enable you to avoid or at least minimize the forgiveness of indebtedness income is with respect to the following circumstances:

1. A discharge of debt in a Chapter 11 bankruptcy proceeding;
2. A discharge of debt when the taxpayer is insolvent (outside of bankruptcy);
3. A discharge of qualified farm indebtedness; or
4. A discharge of qualified real property business indebtedness.

The rules applicable to discharge of indebtedness income, and the related exceptions, are complicated. If you are faced with the potential of having a discharge of indebtedness income, you should discuss the situation with your tax preparer or another qualified tax adviser.