Taxes on Cancelled Debt: What You Need to Know

Having debt forgiven or cancelled can feel like a blessing – but it can also create a tricky tax situation. If you’ve had debts cancelled or discharged recently, you may be wondering how it affects your taxes. As a financial services company, we want to provide some guidance on the tax implications of cancelled debt.When a lender forgives or cancels a debt you owe, the IRS typically considers that cancelled debt as taxable income. So if you had $10,000 in credit card debt forgiven, the IRS sees it as you receiving $10,000 in income.There are some exceptions to this rule, which we’ll explain. But in most cases, any cancelled debt over $600 will be reported to the IRS and you’ll owe income tax on it.We know taxes on cancelled debts can be confusing. This article will break down when cancelled debt is taxable, exceptions to the tax rules, and how to handle it on your tax return. Our goal is to make this clearer so you can make informed choices if you’ve had debts discharged.

When Cancelled Debt Becomes Taxable Income

In the eyes of the IRS, when a lender forgives a debt you owe – whether it’s a credit card, personal loan, mortgage, or other debt – they are essentially giving you money.And just like any other income you receive, forgiven debts may be taxable. Here are some examples of when cancelled debt typically becomes taxable income:

• Credit card company writes off your unpaid balance
• Mortgage lender agrees to a short sale for less than you owed
• Personal loan is forgiven through a debt settlement program
• Debt collector agrees to settle a past-due bill for less than the full amount

The lender is not required to forgive the debt. But when they do, the amount forgiven becomes taxable income to you in most cases.The lender will report the forgiven debt to the IRS on a 1099-C form. And you’ll need to report it as income on your tax return, just like your wages from a job or other earnings.

Exceptions: When Cancelled Debt Is Not Taxed

There are some exceptions where you may be able to exclude cancelled debt from your taxable income:Bankruptcy: Debt discharged through bankruptcy is not taxable in most cases. This includes Chapter 7 liquidation and Chapter 13 restructuring.Insolvency: If your total liabilities exceeded your total assets (meaning you were insolvent) at the time of the debt cancellation, that amount may not be taxable.Student Loans: Federal student loans forgiven through income-driven repayment plans are not taxable through 2025. Private student loans forgiven due to death or permanent disability are also exempt.Mortgage Debt (with limits): Up to $750,000 in forgiven mortgage debt from your primary residence can be excluded from taxes, through 2025. This applies to loan principal, not interest.Gifts: If a relative or friend forgives a personal loan as a gift, this is not taxable income. But they may need to file a gift tax return if over the annual exclusion amount.Deductible Debt: Forgiven debt is not taxable if the interest was tax deductible, like on a business loan or mortgage. This does not apply to the principal, only deductible interest.So in cases like these, you may be able to avoid owing income tax on cancelled debt. Make sure to work with a tax professional to determine if you qualify for one of these exceptions.

How Cancelled Debt Appears on Your Taxes

If you receive a 1099-C form reporting cancelled debt of $600 or more, you typically must include this amount as income on your tax return. Here’s how it works:

• The creditor or lender files Form 1099-C with the IRS showing the amount of debt forgiven
• You receive a copy of Form 1099-C for the tax year when the debt was cancelled
• On your Form 1040, you report the forgiven debt amount as income on the appropriate line
• If you qualify for an exception, use Form 982 to list the exclusion and excluded amount

Even if you can exclude the cancelled debt from your income, you may still receive a 1099-C. Be sure to properly account for any allowable exceptions on your return.Including the 1099-C amount on your tax return ensures you avoid penalties for underreporting income. Failing to report cancelled debt can lead to IRS audits, interest charges, and additional fines.

The Impact on Your Finances

Having debt forgiven can improve your financial situation by eliminating burdensome monthly payments. But the tax bill on cancelled debt may reduce these benefits.

• Additional income from cancelled debt could bump you into a higher tax bracket
• Owing extra tax may negate the cash flow relief from discontinued loan payments
• If you cannot pay the tax bill immediately, you may need to set up a payment plan with the IRS

The additional tax liability can come as a surprise if you’re not prepared. We recommend talking to a tax professional to understand the impact beforehand, so you can plan accordingly.

Strategies for Handling Taxes on Cancelled Debt

If you will owe income tax on discharged debt, here are some tips to make it more manageable:

• Set aside a portion of your discontinued loan payments to save for the tax bill.
• Explore IRS payment plans if you cannot pay in full. Interest and penalties apply but it spreads payments out.
• File for an extension if you need more time to gather funds or determine exclusions.
• Amend a prior year’s return if you qualify for a retroactive exclusion, to recoup some tax paid.
• Consider credit counseling to improve cash flow going forward, so you can handle the extra tax burden.
• Discuss options with the creditor, like restructuring payments to help cover taxes owed.

The Takeaway on Taxes and Cancelled Debt

Having debt forgiven can be a huge relief but also creates tax headaches in many cases. If you are considering debt settlement or cancellation, be sure to plan for the tax impact.The exceptions we covered can potentially reduce or eliminate taxes owed on discharged debt. Work with a tax professional to determine if you qualify. And allow time to set aside funds once you know the amount of taxable income.While paying taxes on cancelled debt can reduce the financial benefits, it is often still favorable compared to staying trapped paying off the full balances. Just make sure you understand the tax implications first, so you go into it with eyes wide open.We hope this overview helps provide clarity on the tax rules for cancelled debt. Reach out with any other questions! Our team is happy to help you understand this complex topic.