8131 / Under what circumstances is discharge of debt income excluded from gross income?

Editor’s Note: Under the 2017 tax reform legislation, income resulting from the discharge of student loan debt because of the death or permanent and total disability of the borrower is not included in taxable income.¹ This provision is effective for loans that are discharged after December 31, 2017.

Depending on the circumstances of the discharge, IRC Section 108 provides a number of discharge of debt exclusions from gross income. If applicable, in spite of the economic benefit of the debt forgiveness, the ensuing income escapes taxation. As discussed below, in some cases, however, IRC Section 108 requires the taxpayer to reduce certain tax attributes (specifically enumerated deductions or credits that would otherwise reduce the taxpayer’s tax liability) up to the amount excluded from gross income. Importantly, the exclusion is not conditioned on a dollar for dollar reduction of those specific tax attributes. In other words, it does not matter whether the taxpayer possesses any of those enumerated tax attributes or, if possessed, in an amount equal to the excluded discharge of debt income. In either case, the full amount of discharge of debt income is excluded.

On the other hand, to the extent a taxpayer does possess some or all of those specific tax attributes, the mandatory reduction transforms IRC Section 108 from an income exclusion section to an income deferral section. This is because reducing a tax attribute by an equivalent amount of excluded discharge of debt income effectively offsets the tax savings of the exclusion.

Example: In January 2026, Asher files a Chapter 7 bankruptcy petition. In September 2026, the bankruptcy court grants Asher a discharge of $10,000 of credit card debt. Pursuant to IRC Section 108(a)(1)(A), the discharge of the $10,000 debt in bankruptcy is excluded from gross income. However, pursuant to IRC Section 108(b)(2), Asher must reduce certain tax attributes (up to the amount of the excluded income) in the order listed. Consequently, Asher who has a $10,000 NOL (the first listed tax attribute) must reduce it to zero (by subtracting the excluded amount of discharge of debt income).

Subsequently, in 2027, Asher has $10,000 of taxable income. If the $10,000 NOL had remained intact, deducting it would have completely offset the taxable income resulting in no tax. Because the NOL was eliminated through a tax attribute reduction, however, Asher must pay tax on the full $10,000 of taxable income. Thus, the tax benefit of the excluding the $10,000 of discharge of debt income in 2026 is offset by the loss of the $10,000 NOL deduction in 2027.