For tax purposes don't think that you're off the hook if another party forgives or cancels a debt. Under the "cancellation of debt" (COD) provision in the tax law, this seemingly generous act could result in an unexpected tax bill.

Some businesses and organizations must file Form 1099-C, Cancellation of Debt, when they forgive debts over a certain amount.

Personal Debts: How One Taxpayer Got Stung Twice

If one party "forgives" all or part of an amount owed, the other party may be required to pay tax on the value of the discharged debt, under the "cancellation of debt" (COD) rules.

In one case, a taxpayer was liable for the tax on COD income even though he didn't incur the liability.

The facts: Charles Anderson allowed a friend to use his Citibank credit card. Although the account was under Anderson's name, the friend agreed she would be responsible for amounts she charged. However, Anderson was still legally obligated to Citibank.

The friend rang up close to $4,600 in bills that she did not pay. After being contacted by a collection agency, Anderson settled the account for 70 percent of the past due amount. Citibank reported to the IRS almost $1,400 in income resulting from the discharge of the debt. Despite Anderson's claim that he never received notification of the liability, the Tax Court ruled the amount was taxable to him. (Anderson, TC Summary Opinion 2003-169)

Basic rules: If an amount you owe is forgiven or canceled, you must generally report it as taxable income on your personal tax return. A forgiven business debt is reported as income on the appropriate form for the business entity or sole proprietorship.

For this purpose, a "debt" includes any financial obligation for which you are legally liable or which attaches to property you own.

Similarly, you are required to report any interest attributable to the debt that is forgiven or canceled.

However, there are several notable exceptions to the taxation of canceled debt income, including the following seven:

1. Student loans - Certain student loans are exempt if you're required to work after school for a specified time for a certain type of employer. Other qualified student loans issued by tax-exempt organizations may also be tax-free if they are forgiven.

2. Deductible debt - You do not have to realize COD income if the payment of debt would have been tax-deductible. This exception only applies if you use the cash method of accounting.

3. Price reduction - If a seller reduces the amount of debt owed for property you've purchased, the reduction generally is treated as a non-taxable price reduction. However, this reduces your basis in the property.

4. Bankruptcy debt - Certain debts that are canceled because you're insolvent or in bankruptcy proceedings are exempt.

5. "Qualified farm debt" may be exempt.

6. Mortgage debt -- Under a housing law passed in 2008, the first $2 million of qualified mortgage debt may be forgiven tax-free.

7. Gifts - A legitimate gift does not result in COD income.

It is recommended that you meet with your tax professional to determine the tax consequences of debt forgiveness or cancellation. If you're aware of an upcoming transaction that could result in a debt being extinguished prematurely, it may be possible to structure an arrangement to your tax advantage.