Gus owes $50,000 in credit card debt to Neighbor's Bank. Gus was having financial difficulties during the current year and Neighbor's Bank agreed to reduce Gus's debt to $20,000 to help him get his financial affairs in order and avoid bankruptcy.
I.If Gus's assets were $100,000 and his liabilities were $150,000 before the discharge, he is not taxed on any of the $30,000 debt reduction.
II.If Gus's assets were $80,000 and his liabilities were $100,000 before the discharge, he is taxed on all $30,000 of the debt reduction.

Question

Gus owes $50,000 in credit card debt to Neighbor's Bank. Gus was having financial difficulties during the current year and Neighbor's Bank agreed to reduce Gus's debt to $20,000 to help him get his financial affairs in order and avoid bankruptcy.
I.If Gus's assets were $100,000 and his liabilities were $150,000 before the discharge, he is not taxed on any of the $30,000 debt reduction.
II.If Gus's assets were $80,000 and his liabilities were $100,000 before the discharge, he is taxed on all $30,000 of the debt reduction.
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Quizplus · Accepted Answer

Statement I is correct because the debt reduction of $30,000 is not included in Gus's taxable income if his liabilities exceed his assets before and after the debt forgiveness. This is known as the insolvency exclusion.

Statement II is incorrect because even if Gus's liabilities exceed his assets before the debt forgiveness, if his assets are still greater than his liabilities after the forgiveness, he may be taxed on a portion of the debt reduction. This is known as the potential taxability of debt forgiveness income.

Gus Owes $50,000 in Credit Card Debt to Neighbor's Bank