In which situation does the cancellation of debt result in income inclusion?

The situation in which the cancellation of debt results in income inclusion is when the debtor was solvent at the time of debt cancellation. Generally, if a debtor's debt is canceled, the amount canceled is considered income and must be included in the debtor's taxable income. This is because the cancellation of debt is viewed as an economic benefit that increases the debtor's wealth.

When a debtor is solvent at the time of cancellation, the IRS does not provide any exclusion for the canceled debt amount. Therefore, it is fully taxable. In contrast, if the debtor is insolvent (meaning their liabilities exceed their assets) at the time of cancellation, they may be eligible for an exclusion under the insolvency rule, which allows them to exclude the canceled amount from taxable income to the extent of their insolvency.

Additionally, debts canceled as gifts or through bankruptcy proceedings typically fall under specific exclusions or treatment that can result in no income inclusion. Gifts are not considered taxable income to the recipient, while debts discharged in bankruptcy are also not considered taxable income.