The general rule when it comes to debt forgiveness is that it is taxable. But there are some exceptions. The most common situations when debt forgiveness income is not taxable involve bankruptcy, the Mortgage Forgiveness Debt Relief Act, insolvency, and certain farm and business indebtedness.

Discharges in bankruptcy can generally be excluded. If you think that this exclusion applies to you, make sure to discuss it with your attorney and CPA. I find that all too often people think this applies to them, but the debt forgiveness either occurred before or after the bankruptcy.

Another exclusion is available under the Mortgage Foregiveness Debt Relief Act. This Act came into place in 2007 and allows certain exclusions through 2012. This Act applies to qualified indebtedness (purchase money and/or original acquisition indebtedness) on a principal residence. Many homeowners will qualify under the Act, but be careful if you did a cash-out refinance or took out a second mortgage. This is where people often run into trouble.

If the debt foregiveness relates to your primary residence and you don’t qualify under the Act, you may very well qualify under the insolvency exclusion. The insolvency exclusion is complex and I will dedicate a separate blog post just to tackle this issue. Let’s just say for now that if you don’t have many assets and you have substantial liabilities you may be able to exclude certain debt forgiveness from income.

You can exclude certain farm debt forgiveness from income. Generally, if the debt was incurred directly in the operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your debt forgiveness is generally not considered taxable income.