What Is IRS Section 108? Exclusions and Attribute Reduction

The IRS Section 108 canceled debt exclusions let you keep forgiven debt out of your taxable income in four main situations: debt discharged in bankruptcy, debt canceled while you were insolvent, certain qualified farm debt, and certain commercial real estate debt. A fifth exclusion for mortgage debt on a primary home largely expired at the end of 2025. Each exclusion has its own eligibility rules and, for most of them, a tradeoff: you have to reduce future tax benefits by the amount you exclude.

Why Canceled Debt Is Taxable in the First Place

Section 61 of the Internal Revenue Code defines gross income as all income from whatever source, and it specifically names discharge of indebtedness.¹ If a creditor forgives what you owe, the IRS treats the forgiven amount as money you effectively received, taxed as ordinary income at your marginal rate. For 2026, those rates run from 10% to 37%.²

This shows up in familiar situations. A lender forgives a mortgage deficiency after a foreclosure or short sale. A bank reduces principal in a loan modification. You settle a $10,000 credit card balance for $3,000, producing $7,000 of cancellation of debt (COD) income. Whenever $600 or more is canceled, the creditor files Form 1099-C with the IRS and sends you a copy.³ You owe tax on that amount unless a specific exclusion applies. Section 108 is where those exclusions live.

The Bankruptcy Exclusion

The broadest exclusion applies to debt discharged in a Title 11 bankruptcy case. If you filed under Chapter 7, 11, or 13 and the court orders or approves the discharge, the entire canceled amount is excluded from your income with no dollar cap.⁴ It is the only Section 108 exclusion without a ceiling.

Two conditions matter. You must be a debtor under the jurisdiction of the bankruptcy court at the time of the discharge; debt forgiven outside the formal proceeding does not qualify. And the bankruptcy exclusion takes priority over every other Section 108 provision. If you are in bankruptcy, you use this exclusion rather than claiming insolvency or any other category.

The Insolvency Exclusion

If you are not in bankruptcy but your total liabilities exceeded the fair market value of everything you owned immediately before the debt was canceled, you were insolvent under Section 108. You can exclude COD income up to the amount by which you were insolvent.⁴ The cap is the amount of insolvency, not the full canceled debt.

Say a creditor forgives $100,000 and your liabilities exceeded your assets by $60,000 immediately before that cancellation. You exclude $60,000 and pay tax on the remaining $40,000. If insolvency had equaled or exceeded $100,000, the whole amount would come out.

Getting the Insolvency Calculation Right

This is where most insolvency claims fall apart. You have to count everything you own at fair market value, including assets that surprise people. Retirement accounts, pension plan interests, and property that creditors cannot legally touch all count as assets for this test.⁵ A 401(k) protected from creditors in bankruptcy still counts here.

On the liability side, you include the full amount of any debt for which you are personally liable (recourse debt). For nonrecourse debt, where the lender can only seize the collateral, you include the debt only up to the collateral’s fair market value, plus any forgiven amount that exceeds that value.⁵ Real property usually needs a formal appraisal. Document everything, because the IRS can and does challenge insolvency claims.

Qualified Farm Indebtedness

Farmers have a dedicated exclusion with three conditions, all of which must be met:⁴

The debt was incurred directly in connection with operating a farming business.
At least 50% of your total gross receipts over the three preceding tax years came from farming.
The debt was canceled by a qualified person, which includes banks, credit unions, and any federal, state, or local government agency.

The exclusion is capped at the sum of your adjusted tax attributes plus the adjusted basis of qualified property (assets used in a trade or business or held for income production) as of the start of the following tax year. If you also qualify for the insolvency exclusion, insolvency is applied first, and the farm exclusion covers any remaining COD income up to its own cap.

Qualified Real Property Business Indebtedness

Commercial real estate owners can elect to exclude COD income on what the code calls qualified real property business indebtedness (QRPBI). The debt must have been taken on in connection with real property used in a trade or business and secured by that property. C corporations cannot use this exclusion, and it generally does not apply to residential rental property held by individual investors unless the activity is truly a trade or business.⁴

The excluded amount faces two caps. You cannot exclude more than the difference between the outstanding loan balance and the property’s fair market value (after any other debt secured by the same property). And the total exclusion cannot exceed the aggregate adjusted basis of your depreciable real property, reduced by any depreciation already claimed for the year and other required Section 108 basis reductions.⁶ Attribute reduction here is narrower than for bankruptcy or insolvency: you reduce only the basis of your depreciable real property.

The Principal Residence Exclusion Has Largely Expired

For years, homeowners could exclude up to $2 million of forgiven mortgage debt on a primary residence ($1 million if married filing separately), covering many foreclosures, short sales, and loan modifications. Only debt used to buy, build, or substantially improve the residence qualified.

The statute only covers debt discharged before January 1, 2026, or debt discharged under a written arrangement entered into before that date.⁴ Mortgage debt forgiven in 2026 without a qualifying written pre-2026 agreement no longer gets this exclusion. Legislation to make the provision permanent has been introduced but not enacted.

Homeowners who lose this exclusion often still qualify under insolvency. Someone whose home was foreclosed frequently had liabilities exceeding assets at the moment of discharge, which is the test that matters. The insolvency route just takes more documentation than checking a box.

The Catch: Attribute Reduction

The Section 108 exclusions for bankruptcy, insolvency, and farm debt are closer to a deferral than a free pass. In exchange for excluding COD income now, you must reduce your tax attributes, meaning items that would otherwise cut your future taxes. The statute sets a mandatory order, and you apply the excluded amount to each category before moving to the next:⁷

Net operating losses (NOLs), reduced dollar for dollar, starting with the loss for the discharge year and then any carryovers.
General business credits, reduced at 33⅓ cents per dollar of excluded income (reflecting that credits offset tax directly, not just income).⁴
Minimum tax credits, also at the 33⅓ cents rate.
Capital loss carryovers, dollar for dollar.
Basis of property, both depreciable and non-depreciable, held at the start of the next tax year, dollar for dollar.
Passive activity loss and credit carryovers, dollar for dollar.
Foreign tax credit carryovers, at the 33⅓ cents rate.

Basis reduction hits individuals hardest, because many have few of the other attributes. When basis drops, you recognize a larger gain when you eventually sell the property. If the property is depreciable, your annual depreciation deductions shrink right away. The tax you avoided this year reappears later.

Electing to Reduce Basis First

The statute gives you one strategic lever. You can elect to reduce the basis of depreciable property before touching any other attribute. This makes sense when you have valuable NOLs you expect to use soon against high-bracket income. Sacrificing depreciation deductions preserves the NOLs. The election is made on Form 982 filed with your return for the discharge year, and once made it is generally irrevocable.⁸

Claiming the Exclusion on Your Return

You claim a Section 108 exclusion on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, filed with your federal return for the year the debt was discharged.⁸ Part I identifies which exclusion applies. Part II reports the attribute reductions. Your Form 1040 shows the COD income from the 1099-C, and Form 982 creates the offsetting exclusion so you are not taxed on the excluded portion.

For an insolvency claim, keep detailed records of every asset and liability valued as of the moment before the discharge. The IRS publishes an insolvency worksheet in Publication 4681 that walks through the calculation. Complete it even though you do not file it; if the IRS questions the exclusion, that worksheet is your defense.⁵

When the 1099-C Is Wrong

Sometimes a 1099-C reports debt you do not actually owe or the wrong amount. Contact the creditor first and ask for a correction. If the creditor refuses, report the amount shown but include a written explanation on your return stating why the figure is wrong.⁹ A 1099-C can also arrive while the creditor is still trying to collect, which does not necessarily mean the debt was actually canceled. Verify before treating it as COD income.

State tax treatment is a separate issue. Not every state follows the federal Section 108 exclusions. Some conform fully, some selectively, and a few write their own rules. Check your state before assuming the federal exclusion carries through.

1
Office of the Law Revision Counsel. 26 USC 61 Gross Income Defined
2
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
3
Internal Revenue Service. About Form 1099-C, Cancellation of Debt
4
Office of the Law Revision Counsel. 26 USC 108 Income From Discharge of Indebtedness
5
Internal Revenue Service. Publication 4681 (2025), Canceled Debts, Foreclosures, Repossessions, and Abandonments
6
eCFR. 26 CFR 1.108-6 – Limitations on the Exclusion of Income From the Discharge of Qualified Real Property Business Indebtedness
7
eCFR. 26 CFR 1.108-7 – Reduction of Attributes
8
Internal Revenue Service. Instructions for Form 982
9
Taxpayer Advocate Service. I Have a Cancellation of Debt or Form 1099-C