Gross income is the starting point in computing the taxable income upon which individuals are subject to income tax. Gross income is a broad concept that includes all income (whether derived from labor or capital) excluding those items that are specifically identified by statute, and, thus, not taxable. For example, gross income includes salary, fees, commissions, business profits, interest and dividends, rents, alimony received prior to 2019, and gains from the sale of property – but not the mere return of capital expended by the taxpayer to purchase or improve the property.¹

Planning Point: Note that unemployment compensation is typically included in gross income. For 2020 only, the American Rescue Plan Act (ARPA) excluded the first $10,200 ($24,000 for joint returns) in unemployment compensation from income. The exclusion applies only for taxpayers with modified adjusted gross income that does not exceed $150,000.

The following is a non-exhaustive list of items that are excluded from gross income and received income tax-free by an individual taxpayer:

1. Gifts and inheritances²
2. Gain (within limits) from the sale of a personal residence (see Q 8647)
3. 50 percent of gain (within limits) from the sale of certain qualified small business stock held for more than five years (see Q 8608)
4. Interest on many bonds issued by a state, city or other political subdivision
5. Social Security and railroad retirement benefits (within limits – see Q 8569 to Q 8572); veterans’ benefits (but retirement pay is taxable)³
6. Workers’ Compensation Act payments (within limits)⁴
7. Death proceeds of life insurance and, as to death proceeds of insurance on the life of an insured who died before October 23, 1986, up to $1,000 annually of interest received under a life income or installment option by a surviving spouse⁵
8. Amounts paid or expenses incurred by an employer for qualified adoption expenses in connection with the adoption of a child by an employee if the amounts are furnished pursuant to an adoption assistance program⁶
9. Contributions to a “Medicare Advantage MSA” by the Department of Health and Human Services⁷
10. Exempt-interest dividends from mutual funds
11. Interest on certain U.S. savings bonds purchased after 1989 and used to pay higher education expenses (within limits)⁸
12. Contributions paid by an employer to Health Savings Accounts (HSAs)⁹
13. Distributions from HSAs used to pay qualified medical expenses¹⁰
14. Federal subsidies for prescription drug plans¹¹

Adjusted gross income is broadly defined as gross income minus certain specifically deductible items allowed by the Code. Deductions from gross income, also referred to as above-the-line deductions, are the most tax beneficial type of deductions because they tend to be taken dollar-per-dollar with fewer limitations than what are known as below-the-line or itemized deductions. Additionally, as a measuring tool, adjusted gross income is important because many thresholds upon which tax benefits phase out or taxes phase in are directly tied to adjusted gross income (for example, subject to the taxpayer being able to itemize, medical expenses are deductible only to the extent that they exceed 7.5 percent (10 percent in earlier years) of adjusted gross income for the tax year).

The Code specifically designates which deductions are subtracted from adjusted gross income as above-the-line deductions. The following is a list of deductions permitted by the Code:

1. Expenses directly incurred in carrying on a trade, business or profession (not as an employee – see Q 8524)
2. The deduction allowed for contributions made by a self-employed individual to a qualified pension, annuity, or profit sharing plan, or a simplified employee pension or SIMPLE IRA plan
3. Certain reimbursed expenses of an employee in connection with employment, provided the reimbursement is included in gross income (if the employee accounts to his employer and reimbursement does not exceed expenses, reporting is not required)
4. Deductions related to property held for the production of rents and royalties (within limits)
5. Deductions for depreciation and depletion by a life tenant, an income beneficiary of property held in trust, or an heir, legatee or devisee of an estate
6. Deductions for losses from the sale or exchange of property
7. The deduction allowed for amounts paid in cash by an eligible individual to a traditional individual retirement account (IRA), or individual retirement annuity
8. The deduction allowed for amounts forfeited as penalties because of premature withdrawal of funds from time savings accounts
9. Alimony payments made to the taxpayer’s spouse (this provision was repealed; alimony payments are now includable in the income of the payor spouse and excluded from the recipient’s income for tax years beginning after 2018)
10. Certain reforestation expenses
11. Certain jury duty pay remitted to the taxpayer’s employer
12. Moving expenses permitted by IRC Section 217 (generally suspended for 2018-2025)
13. The deduction for Archer Medical Savings Accounts under IRC Section 220(i)
14. The deduction for interest on education loans
15. The deduction for qualified tuition and related expenses
16. The deduction for contributions (within limits) to Health Savings Accounts
17. The deduction for attorneys’ fees involving discrimination suits
18. The deduction for certain expenses of elementary and secondary school teachers up to $250 (this provision was made permanent by the Protecting Americans from Tax Hikes Act of 2015 (PATH)). PATH also provided that the $250 dollar limit will now be adjusted annually for inflation (the amount is $300 in 2022-2024 and $250 in 2020 and 2021).

Editor’s Note: Under the 2017 tax reform legislation, income resulting from the discharge of student loan debt because of the death or permanent and total disability of the borrower is not included in taxable income.¹ This provision is effective for loans that are discharged after December 31, 2017.

Editor’s Note: Congress extended the treatment of qualified principal residence indebtedness, discussed below, through the 2025 tax year. Congress has not yet extended this treatment for tax years beyond 2025.

If a creditor of a taxpayer discharges all or part of a debt for no consideration, the amount of debt discharged is potentially taxable to the taxpayer.² However, such debt discharge is excluded from gross income; and, thus not taxable, if the discharge: (1) occurs in a bankruptcy; (2) occurs when the taxpayer is insolvent and the discharge does not render the taxpayer solvent; (3) the indebtedness discharged is “qualified farm indebtedness;”³ (4) in the case of a taxpayer other than a C corporation, the indebtedness discharged is “qualified real property business indebtedness;” or (5) the indebtedness discharged is “qualified principal residence indebtedness” (see “Mortgage Forgiveness Debt Relief Act of 2007,” below) that is discharged before January 1, 2026 (but see editor’s note, above).⁴

Importantly, as stated above, “discharge of debt income” is triggered when a debt is forgiven for no consideration. Therefore, if any consideration is involved, it would not be considered discharge of indebtedness income. Significantly, under those circumstances, the so-called discharge is completely taxable as none of the above exclusions would apply.

Example: Asher borrows $10,000 from his employer. Instead of repaying the loan, his employer forgives the debt after Asher works 200 hours of overtime. In other words, it is as if the employer paid Asher $10,000 for his services; which, Asher, in turn used to repay the loan. Thus, the discharge of the loan is essentially compensation for services, or taxable wage income (not discharge of debt income).

In some cases, even though consideration is involved, the discharge of debt may not necessarily be taxable. For example, suppose a shareholder of a corporation loans $10,000 to the corporation. Subsequently, the shareholder forgives the loan for no consideration. Because the loan comes from someone with shareholder status, the proceeds of the forgiven loan that remain in the corporation are essentially a capital contribution to the corporation. It is as if the corporation repaid the loan to the shareholder, who, in turn, made a capital contribution to the corporation. Contributions to a corporation are not taxable to the corporation. So in this case, discharge of debt that is the equivalent of a capital contribution does not trigger taxable income.⁵