Have a Tax Question? Ask a Tax Expert
Yes, if the person is unable to pay the loan and the loan is cancelled or forgiven than that person has to include the forgiven/cancelled loan as income.
However-You do not owe tax on the forgiven or cancelled debt if you meet the insolvent exception.
You are considered insolvent if your liabilities are more than your assets.
Here is extract from the IRS website with more information and also a link to the site
Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities exceeded the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include:
The entire amount of recourse debts, and
The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt.
This exclusion does not apply to a cancellation that occurs in a title 11 bankruptcy case. This exclusion also does not apply if the debt is qualified principal residence indebtedness unless you elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion.
How to report the insolvency exclusion. To show that you were insolvent and that you are excluding canceled debt from income to the extent you were insolvent immediately before the cancellation, attach Form 982 to your federal income tax return and check the box on line 1b. On line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation. You must also reduce your tax attributes in Part II of Form 982.
Let me know if you have any question.
Please note: This advice is provided with the understanding that all the relevant facts have been provided by you. Any change in facts might affect the advice given and hence may not be relied on in such cases. Nothing contained in this reply was intended or written to be used, can be used by any taxpayer, or may be relied upon or used by any taxpayer for the purposes of avoiding penalties that may be imposed on the taxpayer under the Internal Revenue Code of 1986, as amended.