In this still-lousy economy, debts can pile up beyond one's ability to repay. The only good news is that lenders are sometimes willing to forgive debts that are owed by especially beleaguered folks. While this can help you survive financially, it can also trigger negative tax consequences -- but maybe not. This column summarizes what you need to know about the tax rules for cancelled debts.

Cancellation of Debt Income Is Generally Taxable

When a lender forgives part or all of a debt, it results in so-called cancellation of debt (COD) income. The general rule is that COD income counts as taxable income. For the year when COD income occurs, the lender is supposed to report the forgiven amount to the borrower, and to the Internal Revenue Service, too, on Form 1099-C (Cancellation of Debt).

Beneficial Exceptions Grant Tax-Free Treatment to Eligible Individuals

Thankfully, there are several favorable exceptions to the general rule that COD income is taxable. Here are the ones that are most likely to help individual borrowers out.

Bankruptcy Exception

If the borrower is in Title 11 bankruptcy proceedings when the COD income occurs, the income it is completely exempt from federal income taxation. Title 11 encompasses bankruptcy filings under Chapter 7 (so-called liquidations), Chapter 11 (so-called reorganizations), and Chapter 13 (so-called wage earner filings). Legislation passed back in 2005 made it more difficult to file under Chapter 7 and thereby be completely exonerated from unsecured debts such as credit-card balances. However, COD income still occurs in Chapter 7 cases (just not as often as before), and COD income still occurs in some Chapter 11 and Chapter 13 cases as well.

Insolvency Exception

When the borrower is insolvent (meaning with debts in excess of the fair market value of his or her assets) immediately before debt cancellation occurs, the resulting COD income is exempt from federal income taxation to the extent of that insolvency. However, when the debt cancellation effectively makes the borrower solvent (because assets now exceed debts), the COD income is taxable to the extent the borrower is made solvent. The rest of the COD income (if any) is exempt from taxation under the insolvency exception.

Home Mortgage Exception

Legislation enacted in 2007 and 2008 created an exception for qualifying cancellations of home mortgage debt that occur in 2007 through 2012. Whether the exception will be extended beyond this year depends on our beloved Congress. In any case, you need not be bankrupt or insolvent to take advantage of this deal--which allows an individual to have up to $2 million of federal-income-tax-free COD income from forgiven qualified principal residence debt. This means debt that was used to acquire, build, or improve your main residence and that is secured by that residence. Refinanced debt can also qualify for this exception to the extent it replaces debt that was used to acquire, build, or improve your principal residence. You must reduce the tax basis of your residence (but not below zero) by the amount of COD income that you are allowed to treat as tax-free under this exception.

Beware: This home mortgage exception is not available for COD income from forgiven second mortgages, HELOCs, vacation home mortgages, or rental property mortgages.

Deductible Interest Exception

To the extent COD income consists of unpaid interest that was added to your loan principal and then forgiven, any forgiven interest that you could have deducted--if you had paid it--is exempt from federal income taxation. This exception often comes into play with forgiven principal residence mortgage interest, vacation home mortgage interest, and rental property mortgage interest.

Seller-Financed Debt Exception

When COD income is from seller-financed debt (meaning mortgage debt owed by you to the previous owner of a property that you purchased), the COD income is exempt from federal income taxation. However, your basis in the property must be reduced by the amount that you are allowed to treat as tax-free under this exception.

The Bottom Line

There are some other more arcane exceptions to the general rule that COD income is taxable, but I'm not going to cover them here because it could result in a whole book. (Consult your tax pro if you have questions after reading this.)

You should also know that the Internal Revenue Code extracts a price for exempting COD income from taxation under the bankruptcy and insolvency exceptions. You must reduce so-called tax attributes such as capital loss carryovers, tax credit carryovers, and the tax basis of certain assets (used to calculate tax gains and losses on sale and depreciation deductions) as the payback for tax-free treatment of COD income. See IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness), which must be filed with your Form 1040. You must also file Form 982 if you take advantage of the home mortgage exception.

The good news is the beneficial exceptions I've just explained can prevent a major tax hit from COD income, which would amount to kicking you when you're already down.