Cancellation of debt means, when a creditor forgives a debt without the consideration in return. Cancellation of debt is considered as an income to the debtor and taxable. If the debtor fails to report it, he/she will receive a 1099-C report stating that the amount of debt forgiven is a taxable income. For example: if a bank lent $10,000 to the debtor and he/she pay back $6,000. Then the bank forgives the remainder $4000, that amount becomes an income of the debtor.
Generally, it is treated as a taxable ordinary income and known as Cancellation Of Debt - COD income. In certain cases, the creditor treated such amounts as gift or exception categories relating to bankruptcies, insolvencies, certain farm loans and non-recourse loans.