If a taxpayer borrows money, the borrowed funds are not included in the taxpayer's gross income. That treatment is proper even though the taxpayer has increased his assets by the amount he borrowed because he also has created a corresponding liability to pay back the loan. The taxpayer's net: wealth has not increased. 'The more difficult and interesting questions arise when the taxpayer fails to repay the loan. At first blush, it would appear that upon cancellation of a loan, the taxpayer should have income for the amount that was cancelled. However, the current tax treatment is not that simple. A number of exceptions exist to the straightforward treatment under which the cancellation requires the taxpayer to recognize income. Some of those exceptions reflect an application of normal tax principles while others exist for programmatic purposes. Those exceptions make the tax treatment of cancellation of debt particularly complex. The goal of this Article is to set out the tax treatment of cancellation of debt, including the many exceptions that apply, it first reviews the history of the cancellation of debt rules, which helps explain how we arrived at the current treatment. It then covers the current statutory treatment of cancellation of debt as well as the many common law rules (such as the transactional approach and the tax benefit rule) that apply.
Kahn, Douglas A. "Cancellation of Debt and Related Transactions." J.H. Kahn, co-author. Tax Law. 69, no. 1 (2015): 161-211.