Where is cancellation of debt income sourced for California purposes, for a business and for a nonresident?

What California taxes as cancellation of debt income

Gross income includes "[i]ncome from discharge of indebtedness" (IRC section 61(a)(11)), and California adopts section 61 through Revenue and Taxation Code sections 17071 and 24271(a). The exclusions follow the same route: section 17131 adopts the federal exclusion provisions, which hold section 108, and section 24307(a) provides that section 108 "shall apply, except as otherwise provided." Discharge income is therefore excluded for California purposes when it is excluded federally for a title 11 case, for insolvency to the extent of the insolvency, for qualified farm indebtedness, or, for a taxpayer other than a C corporation, for qualified real property business indebtedness (IRC section 108(a)(1)(A) to (D)), and the excluded amount reduces tax attributes in the order section 108(b)(2) sets.

California's modifications sit at the edges. Sections 17144 and 24307 reduce credit carryovers at 11.1 cents per dollar rather than 33 1/3 cents, drop the foreign tax credit carryover, make the federal section 108(c) election binding, and provide that section 108(i), the 2009 and 2010 deferral for reacquired business debt, "shall not apply" (Rev. and Tax. Code sections 17144(a) to (f), 24307(b) to (f), (i)). The qualified principal residence exclusion of section 108(a)(1)(E) has a California counterpart in section 17144.5, with lower limits ($500,000 of excluded debt relief, $250,000 for a married individual filing separately, and $800,000 of acquisition debt). The Franchise Tax Board's page on mortgage forgiveness debt relief, updated December 17, 2025, states that California's relief reaches discharges before January 1, 2014, and that a discharge from January 1, 2014 through 2025 that is excluded for federal purposes may be taxable in California, so a homeowner whose lender wrote off recourse mortgage debt in those years may have California income the federal return excludes.

Two mechanical rules decide whose discharge it is and how much of an event is discharge income at all. Section 108(d)(6) applies the exclusions "at the partner level," so a partnership's discharge passes through and each partner's own bankruptcy or insolvency governs; section 108(d)(7)(A) applies them "at the corporate level" for an S corporation, so the corporation's condition governs (FTB S Corporation Manual, chapter 11, Rev. December 2018). On the amount, Treasury Regulation 1.1001-2 governs a transfer of property that secures the debt. For a nonrecourse liability, the amount realized includes the full liability discharged even where the property is worth less (Treas. Reg. 1.1001-2(a)(1), (b), Example 7), so the event is a sale of the property and produces gain or loss, not discharge income. For a recourse liability, the amount realized stops at the property's fair market value and the excess of the debt over that value is income from discharge of indebtedness (Treas. Reg. 1.1001-2(a)(2), Example 8). That split is the first step in every case in which the property is transferred, because gain from California real property and discharge income are sourced under different rules. A Form 1099-C settles nothing: it is deemed a discharge "solely for purposes of the reporting requirements," "whether or not an actual discharge of indebtedness has occurred" (Treas. Reg. 1.6050P-1(a)(1)).

The business taxpayer: business income, and out of the sales factor

For a corporation, and for any taxpayer whose business income is apportioned under the Uniform Division of Income for Tax Purposes Act, the first question is character. Section 25120(a) defines business income as "income arising from transactions and activity in the regular course of the taxpayer's trade or business and includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations," and section 25120(d) makes nonbusiness income "all income other than business income." The Franchise Tax Board reads the definition, after Hoechst Celanese Corp. v. Franchise Tax Board (2001) 25 Cal.4th 508, as "providing two alternative tests," transactional and functional, "the satisfaction of either one of which will result in a determination of business income" (FTB Multistate Audit Technique Manual, section 4010). The regulation adds a presumption: "the income of the taxpayer is business income unless clearly classifiable as nonbusiness income" (Cal. Code Regs., tit. 18, section 25120(a)).

Discharge income does not come from property the taxpayer owns, so the functional test's language about property fits it awkwardly. The transactional test fits it well. A loan taken to build a plant, fund working capital or carry receivables is a transaction in the regular course of the business, and the lender's later agreement to accept less than the balance resolves that same transaction; on the ordinary reading of section 25120(a) and the regulation's presumption, the income is business income. The Franchise Tax Board's only published statement on apportioning the item proceeds from that premise: Technical Advice Memorandum 2015-02 (December 22, 2015) observes that for a taxpayer apportioning under section 25101, discharge income that is not excluded "would be apportioned generally," and holds that excluded discharge income reduces California tax attributes on a post-apportioned basis, since net operating loss and capital loss carryovers are themselves post-apportioned amounts. The nonbusiness argument is available only where the debt itself was outside the business, such as a loan on an investment asset held for nonbusiness purposes. Section 25120(f)(3) removes one shortcut: "[e]xclusion of an item from the definition of 'gross receipts' shall not be determinative of its character as business or nonbusiness income."

The sales factor then leaves the item out. For taxable years beginning on or after January 1, 2011, "sales" means all gross receipts not allocated under sections 25123 to 25127, and "gross receipts" means the gross amounts realized "on the sale or exchange of property, the performance of services, or the use of property or capital ... in a transaction that produces business income" (section 25120(f)(1), (f)(2)). The subdivision lists twelve items that gross receipts, "even if business income, shall not include," among them repayment of loan principal, litigation damages, tax refunds, contributions to capital, treasury function receipts and, at subparagraph (I), "[i]ncome from discharge of indebtedness" (section 25120(f)(2)(A) to (L)). Discharge income is in the apportionable base and out of the factor, numerator and denominator alike; the taxpayer's California percentage is set by its other receipts, and the discharge income is taxed at that percentage. No regulation needs to be invoked: the occasional sale rule of Regulation 25137(c)(1)(A), which excludes substantial receipts from "an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer's trade or business," is about sales and its five percent measure never comes into it. An amount excluded under section 108 stays out of the factor on a second ground as well: Legal Ruling 2006-01 (April 28, 2006) holds that activities generating income excluded from the measure of tax are reflected in the apportionment formula only to the extent of the taxable portion.

An invented example: a solvent corporation has $50 million of gross receipts, $10 million assigned to California, a sales factor of 20 percent, and a lender forgives $8 million of a term loan that financed its operations. The $8 million is business income; the factor remains 20 percent; $1.6 million of the discharge income is taxed in California. Placing the $8 million in the denominator and nowhere in the numerator would have cut the factor to about 17.2 percent, and subparagraph (I) forecloses that result. Had the corporation been insolvent by $8 million or more, the income would be excluded, with the attribute reduction applied to its California attributes on the post-apportioned amount under Technical Advice Memorandum 2015-02.

Nonbusiness discharge income of a corporation: a rule the statute does not supply

Where a corporation can show that discharge income is nonbusiness income, the allocation statutes stop short. Section 25123 provides that "[r]ents and royalties from real or tangible personal property, capital gains, interest, dividends, or patent or copyright royalties, to the extent that they constitute nonbusiness income, shall be allocated as provided in Sections 25124 through 25127." Income from the discharge of indebtedness is on no part of that list. The nearest category, section 25125(c), allocates "capital gains and losses from sales of intangible personal property" to the state of commercial domicile, and a discharge is neither a sale nor a capital gain; the debtor owns no intangible, the creditor does, and what the debtor realizes is ordinary income under section 61(a)(11), not gain from a disposition. The interest and dividend rule of section 25126 does not describe it either.

The result is a gap. Schedule R carries a line for "[m]iscellaneous nonbusiness income (loss)" (2025 Schedule R, Side 1, line 8), so the return can report the amount, but no allocation statute or regulation names the item. The Franchise Tax Board's audit manual states that "[t]he position can be taken" that income section 25123 does not list is allocated to California where it arises from property located or having a situs in California or from activities carried on in California (FTB Multistate Audit Technique Manual, section 4055, citing Rev. and Tax. Code section 23040). No published ruling or Office of Tax Appeals opinion applies that position to discharge income, and a taxpayer might instead reason by analogy to the commercial domicile rule of section 25125(c). For most taxpayers the gap never opens, because the debt that gets discharged is the debt that financed the business; where the facts support nonbusiness treatment, a California-domiciled corporation that calls the item nonbusiness invites full allocation by analogy to the commercial domicile rule, and an out-of-state corporation invites recharacterization or allocation under section 23040.

The nonresident individual: the source follows the debt

A nonresident's California gross income "includes only the gross income from sources within this state" (Rev. and Tax. Code section 17951(a)); a part-year resident includes all income for the resident part of the year and California-source income for the rest (section 17041(i)(1)(A), (B)); and income from within and without the state is allocated and apportioned "under rules and regulations prescribed by the Franchise Tax Board" (section 17954). A full-year resident is taxed on everything regardless of source (section 17041(a)(1)), so the sourcing question arises for the nonresident, and for the part-year resident it turns on the date the discharge occurred, a question of fact that the date on a Form 1099-C does not settle. The regulations under sections 17951 and 17954 do not mention discharge income, so the analysis sorts the debt by what it financed.

Business debt. A nonresident's business carried on entirely within California produces California-source net income in full; one carried on entirely outside produces none; one carried on within and without as a unitary business is apportioned under "Sections 25120 to 25139, inclusive, Revenue and Taxation Code, and the regulations thereunder," and "[t]he source of net income which is not business income shall be determined in accordance with the sourcing rules of Sections 17951 through 17955" rather than the Act's allocation rules (Cal. Code Regs., tit. 18, section 17951-4(a), (b), (c)(2), (c)(3)). The discharge of a sole proprietor's business loan is therefore business income under the same section 25120(a) analysis that governs a corporation, apportioned by the proprietorship's factors with the discharge income itself outside the receipts factor under section 25120(f)(2)(I).

Partnership and S corporation debt. The character of an item is fixed at the entity level. The Office of Tax Appeals, following The 2009 Metropoulos Family Trust v. Franchise Tax Board (2022) 79 Cal.App.5th 245, holds that income from a pass-through entity "is thus characterized at the [pass-through entity] level as either business or nonbusiness income," that "the business income is apportioned under the [UDITPA]," and that "the nonbusiness income is sourced under [R&TC] sections 17951 through 17953 and 17955" (Appeal of L. Smith, 2023-OTA-069P, precedential). The regulation says the same: "the total business income of the partnership shall be apportioned at the partnership level," and a partner's share of items that are not business income is sourced under sections 17951 through 17955 "as if the income producing activity were undertaken by the partner in its individual capacity" (Cal. Code Regs., tit. 18, section 17951-4(d)(1), (d)(4)); subsection (f) applies the partnership rules to a nonresident S corporation shareholder, and subsection (e) routes a member of an LLC taxed as a partnership through subsection (d). An invented example: a Delaware LLC taxed as a partnership operates a distribution business in California and two other states, and its lender forgives $5 million of a credit facility used for inventory and payroll. The $5 million is business income of the LLC; section 108(d)(6) tests each partner's own insolvency, so a solvent nonresident partner includes the full share; and the LLC's apportionment percentage, computed without the $5 million in its receipts factor, fixes the California-source amount on the nonresident's Schedule K-1.

Debt secured by California real property. The federal split comes first. If the loan is nonrecourse and the lender takes the property by foreclosure or deed in lieu, the entire balance is the amount realized, the nonresident has gain or loss from the sale of California real property, and that gain is California-source income under Regulation 17951-3 ("gains realized from the sale or transfer of such property ... regardless of where the sale or transfer is consummated"). There is no discharge income to source. If the loan is recourse, the amount realized stops at fair market value, the gain to that point is sourced to California under the same regulation, and the excess of the debt over value is discharge income whose source the regulations do not state. Section 17952 does not reach it: the statute speaks of a nonresident's income "from stocks, bonds, notes, or other intangible personal property," and a debtor's discharge is not income from property the debtor owns; the mobilia principle the Franchise Tax Board's sourcing manual draws from Miller v. McColgan (1941) 17 Cal.2d 432 locates the creditor's note at the creditor's residence and says nothing about the debtor's side of it. The available hook is the last clause of Regulation 17951-3, which treats as California-source "any other type of income derived from the ownership, control or management of real and tangible personal property located in this State irrespective of whether a trade, business or profession is carried on within this State." Whether a lender's write-off of the unpaid balance of a mortgage is income derived from the ownership of the collateral, or income derived from a debtor-creditor relationship the collateral merely secured, is a question no published Franchise Tax Board ruling, technical advice memorandum or Office of Tax Appeals opinion has answered. The Office of Tax Appeals opinions on discharge income contain no sourcing analysis, and Publication 1100 (2025) and the Residency and Sourcing Technical Manual do not mention the item. A nonresident in this position has a reasoned argument on each side and no authority on either. Where the property was a rental operated as a business, the business debt analysis applies instead.

Personal debt. A nonresident's credit card balance written off by the issuer, a settled personal guarantee of a loan to an out-of-state venture, or a forgiven personal loan has no connection to a California business, property or services. Nothing in sections 17951 through 17955 or the regulations reaches it. The creditor's location is not a sourcing rule; the regulations source a nonresident's income by the location of property, the place a business is carried on or the place services are performed, never by where the lender sits. The same holds for the section 17144.5 nonconformity: a nonresident whose out-of-state home mortgage was written down after 2013 has income California does not exclude, but that income has no California source and never enters the nonresident's California gross income.

Practice notes

The sequence that produces a defensible answer runs from the federal computation to the California one. The first step is the amount: the recourse or nonrecourse character of each discharged obligation, the fair market value of any property transferred, and the resulting split between gain on the property and discharge income under Treasury Regulation 1.1001-2, documented rather than taken from the Form 1099-C. The second is the exclusion level: the partner's own insolvency for a partnership debt, the corporation's for an S corporation, with the section 17144 and 24307 modifications applied to any attribute reduction and, for an apportioning corporation, the post-apportioned amount of Technical Advice Memorandum 2015-02. The third is character under section 25120(a), with the loan documents and the use of proceeds as the evidence that the debt was, or was not, part of the trade or business. The fourth is placement: business discharge income in the apportionable base and out of the sales factor on both sides; nonbusiness discharge income of a corporation reported with a written statement of the allocation position, because no allocation statute names the item; a nonresident's share of entity-level business discharge income carried through the entity's apportionment to the California-source column of the Schedule K-1; and a nonresident's real property discharge income reported on a documented position under Regulation 17951-3, with the gain portion sourced to California in any event. G&G State Tax Group provides characterization, apportionment and nonresident sourcing analysis for debt workouts, foreclosures and restructurings, and representation when the Franchise Tax Board questions the result, alongside its state and local tax practice.