IRC 108 Exclusions: When Canceled Debt Isn't Taxable

By Yarik Yarosh, CPA ·September 5, 2026 ·Updated October 16, 2026 ·6 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

Canceled debt is normally income under IRC 61(a)(11). IRC 108 is the list of exceptions. Gross income doesn’t include debt discharged in a Title 11 bankruptcy case, debt discharged while you’re insolvent (up to the amount you’re insolvent), qualified farm debt, qualified real property business debt (for anyone but a C corporation), and qualified principal residence debt discharged before 2026 or under a written arrangement made before 2026. Bankruptcy overrides the others, and insolvency comes ahead of the farm and real property exclusions. The price is in IRC 108(b): for the bankruptcy, insolvency and farm exclusions, the excluded amount reduces your NOLs, credits, capital loss carryovers and basis, in that order, unless you elect to reduce the basis of depreciable property first.

✓Key takeaway

IRC 108 exclusions from COD income:

Exclusion	Requirement	Limit
Bankruptcy (IRC 108(a)(1)(A))	Discharge occurs in a Title 11 bankruptcy case	Unlimited (all COD income excluded)
Insolvency (IRC 108(a)(1)(B))	Taxpayer is insolvent immediately before the discharge	Limited to the extent of insolvency (liabilities minus FMV of assets)
Qualified farm indebtedness (IRC 108(a)(1)(C))	Incurred by a person engaged in farming, owed to a qualified person	Limited to sum of tax attributes + basis of qualified property
Qualified real property business indebtedness (IRC 108(a)(1)(D))	Acquisition indebtedness on depreciable real property (not C-Corp)	Limited to excess of outstanding debt over FMV of property
Qualified principal residence indebtedness	Acquisition indebtedness on principal residence (through 2025)	Up to $750,000
PPP loan forgiveness	PPP loan forgiven under CARES Act	Unlimited (excluded and no attribute reduction)
Purchase price reduction (IRC 108(e)(5))	Seller reduces debt owed by buyer for purchased property	Limited to debt for the specific property

Tax attribute reduction order (IRC 108(b)):

Priority	Attribute Reduced	Reduction Ratio
1	Net operating losses (NOLs)	Dollar for dollar
2	General business credits	33.33 cents per dollar of excluded COD
3	Minimum tax credits	33.33 cents per dollar
4	Capital loss carryovers	Dollar for dollar
5	Basis of assets (IRC 1017)	Dollar for dollar (cannot go below zero)
6	Passive activity loss carryovers	Dollar for dollar
7	Foreign tax credit carryovers	33.33 cents per dollar
Election	Reduce basis first (IRC 108(b)(5))	Taxpayer can elect to reduce basis before NOLs

How does debt forgiveness affect your taxes?

Hypothetical example

Round numbers. A business owner settled $400,000 of business debt for $200,000, resulting in $200,000 of COD income. Immediately before the discharge:

Item	Amount
Fair market value of all assets	$300,000
Total liabilities (before discharge)	$500,000
Insolvency amount (liabilities minus assets)	$200,000
COD income	$200,000

Scenario 1: Fully insolvent (insolvency equals or exceeds COD)

Item	Amount
COD income	$200,000
Insolvency amount	$200,000
Excluded under IRC 108(a)(1)(B)	$200,000 (100% excluded)
Taxable COD income	$0

Tax attribute reduction required:

Attribute	Before	Reduction	After
NOL carryforward	$80,000	($80,000)	$0
General business credits	$10,000	($10,000) (uses $30,000 of the exclusion at 33 1/3 cents per $1)	$0
Capital loss carryover	$0	$0	$0
Basis of depreciable assets	$150,000	($90,000) (remaining excluded amount, subject to the IRC 1017(b)(2) limit)	$60,000
Total attribute reduction		$200,000

The $116,667 basis reduction means the business will have less depreciation in future years, effectively deferring (not eliminating) some of the tax.

Scenario 2: Partially insolvent

Item	Amount
FMV of assets	$400,000
Total liabilities (before discharge)	$500,000
Insolvency amount	$100,000
COD income	$200,000
Excluded (limited to insolvency)	$100,000
Taxable COD income	$100,000
Tax on $100,000 (37%)	$37,000

Attribute reduction: $100,000 (for the excluded portion only).

Scenario 3: Bankruptcy (Chapter 11)

Item	Amount
COD income	$200,000
Excluded under bankruptcy (IRC 108(a)(1)(A))	$200,000 (100% excluded, no insolvency limit)
Taxable COD income	$0
Attribute reduction required	$200,000 (same ordering rules)

Scenario 4: Qualified real property business indebtedness

Item	Amount
COD income from real property debt	$200,000
Outstanding debt on the property (before discharge)	$600,000
FMV of the property	$450,000
Excess of debt over FMV	$150,000
Excluded under IRC 108(a)(1)(D)	$150,000 (limited to excess)
Taxable COD income	$50,000
Basis reduction (in the property)	$150,000

Form 1099-C issues:

Issue	Details
Lender sends 1099-C but taxpayer disputes the debt	Taxpayer must still report and claim the exclusion (or contest the 1099-C)
Lender does not send 1099-C	Taxpayer is still required to report COD income
Statute of limitations	The debt discharge may restart the collection period for the reduced attributes
1099-C issued in error	File Form 982 with the return explaining the exclusion; attach insolvency worksheet

Form 982 (Reduction of Tax Attributes):

Line	What It Reports
Line 1a	Bankruptcy discharge
Line 1b	Insolvency discharge
Line 1c	Qualified farm indebtedness
Line 1d	Qualified real property business indebtedness
Line 1e	Qualified principal residence indebtedness
Part II	Attribute reduction elections and amounts

Illustrative numbers only, not a real client and not advice for your facts.

Does forgiven debt count as taxable income?

Under the general rule, cancellation of debt (COD) income is taxable as ordinary income. However, several exceptions apply. The insolvency exclusion under IRC 108(a)(1)(B) lets you exclude COD income to the extent your liabilities exceed the fair market value of your assets immediately before the cancellation. Bankruptcy is a complete exclusion: any COD income that arises during a Title 11 bankruptcy case is fully excluded regardless of your financial condition. Other exclusions include qualified farm indebtedness and qualified real property business indebtedness. When you exclude COD income, you must reduce your tax attributes (NOLs, credits, asset basis) by the excluded amount, using Form 982 to report both the exclusion and the attribute reduction.

Two points people get wrong on the insolvency test. First, assets means everything you own at fair market value, including property that secures a loan and exempt assets like retirement accounts and pension interests. Second, when the canceled debt is qualified principal residence debt, that exclusion applies ahead of insolvency unless you elect insolvency instead.

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Cite this page

Yarik Yarosh, CPA. "IRC 108 Exclusions: When Canceled Debt Isn't Taxable." Blue Cloud CPA, September 5, 2026, updated October 16, 2026. https://bluecloudcpa.com/guides/small-business-discharge-of-indebtedness-irc-108-bankruptcy-insolvency

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.

IRC 108 Exclusions: When Canceled Debt Isn't Taxable

How does debt forgiveness affect your taxes?

Does forgiven debt count as taxable income?

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