The term "cancelled" and "discharged" are often used interchangeably, but there is actually an important difference when it comes to how your debt is handled.
When debt is discharged in a bankruptcy case, it effectively becomes noncollectable from the creditors perspective. You, as the debtor, are no longer liable to repay said debt under the protection of your bankruptcy case.
Discharged vs. "Cancelled", "Forgiven" & "Charged-Off" Debt
Outside of a bankruptcy case, there are other times when a liability for debt may be removed, or that account assigned to a different creditor.
For example, if you can negotiate a settlement of debt with your credit card company for less than is owed, the difference is said to have been forgiven or charged off. While this is great for you, there is a new debt for which you are liable, and that is income tax owed to the IRS.
"Forgiven" or Charged-Off Debt is Taxable
It may not make a lot of sense, but if you have any debt that is charged off, the IRS counts it as income for you, and as a result you wind up with a tax liability.
To better illustrate, you must understand what the creditor does with charged off debts. The creditor, as a business, has income and expenses. Expenses are written off as tax deductions. When an expense is written off from taxable income, that equivalent amount must be assigned as income to another party.
For example, if you're a business owner and you write off a truck lease as a business expense, the financial institution that is collecting the lease revenue must pay taxes on it.
Similarly, creditors write off charged-off debts as a business expense. You, as the debtor, are the one benefiting from that expense as "income". The result is the IRS send you a bill for taxes owed on that income.
Debt Discharged in Bankruptcy is Different
Debt discharged in a bankruptcy doesn't get charged off or written off as an expense. Instead, the debt simply become "non-enforceable". For you as the bankruptcy petitioner, it is effectively "dead" debt.
From an IRS income perspective, it is effectively non-taxable income, and you cannot be taxed on it.
