Why are forgiven debts treated as income?
After all it doesn’t really make sense: you don’t actually receive any money when debts are written off, but the IRS may require you to report it anyway. There are a lot of articles on the Internet that tell you that canceled and forgiven debts are considered income, but few if any seem to discuss why this occurs, so let’s look into this.
First, in accounting is a principle called the accounting equation:
Assets = Liabilities + Owner’s Equity
In terms of personal accounting, owner’s equity is your net worth — i.e. the cash value of all of your assets minus your liabilities.
Now whenever you acquire something, such as dining out or buying something for yourself, you incur a liability, convert assets, or lose equity. If you pay with your credit card, you’ve just incurred a liability. If you pay with cash, you either lose equity or you’ve converted assets by trading cash for another asset (such as a car).
There are two ways to cancel liabilities: either by decreasing assets (such as paying it off with cash) or by increasing your net worth. Even if debts are forgiven, this still holds true and cannot be evaded. If part of your debt is canceled, your accounts still have to balance out.
For example, let’s say you have a $1,500 credit card account that you settled for $1,000. That leaves a $500 liability that is no longer a liability. That $500 must be disposed somehow, and it must be disposed in such a way that everything still balances. But how?
Since you aren’t putting any assets toward the liability, the only proper way to dispose of the liability is by converting it to equity. And the only way to effectively convert it to equity is by treating the liability as if it were income. You are basically taking $500 you once owed and adding it to your net worth. This keeps everything balanced out.
In an accounting ledger, this is how it would look:
Here, the "Canceled debt" account is an income account, and when the books are eventually reconciled, that $500 income contributes to your net worth. And it’s because of this that the IRS treats canceled debts as taxable income on the part of the debtor.