Why is Canceled Debt Usually Taxable?
When you borrow money, you typically don’t pay income tax on the amount you receive because you’re expected to repay it. But if a lender later forgives some or all of what you owe, the situation can change.
The IRS generally treats canceled debt as income because you are no longer responsible for repaying money you previously owed.
Key Takeaways
The IRS generally considers canceled or forgiven debt to be taxable income unless an tax problems exception or exclusion applies.
You may qualify for the insolvency exclusion if your total liabilities were greater than the fair market value of your assets immediately before your debt was canceled.
If you use the insolvency exclusion, you’ll generally need to report it to the IRS by filing Form 982 with your federal income tax return.
Cancellation of debt can happen in several situations, including:
- Settling a credit card or personal loan for less than the full amount owed
- Having part of a loan balance forgiven
- Certain foreclosures and repossessions
- Mortgage debt forgiveness
- Certain student loan discharges
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For example, suppose you owe $20,000 on a credit card, and the creditor agrees to accept $12,000 to settle the account. The remaining $8,000 that you no longer have to repay may be considered cancellation of debt income.
However, that doesn’t necessarily mean you’ll owe income tax on the entire $8,000.
What Is Form 1099-C?
If a creditor cancels $600 or more of qualifying debt, you may receive Form 1099-C, Cancellation of Debt.
The form generally includes information such as the amount of debt canceled and the date the cancellation occurred. The creditor may also send a copy to the IRS.
If you receive a 1099-C, don’t assume the entire amount shown on the form is automatically taxable. There are several circumstances in which canceled debt may be excluded from income.
One of those is insolvency.
When you borrow money, you typically don’t pay income tax on the amount you receive because you’re expected to repay it. But if a lender later forgives some or all of what you owe, the situation can change.
The IRS generally treats canceled debt as income because you are no longer responsible for repaying money you previously owed.
Cancellation of debt can happen in several situations, including:
- Settling a credit card or personal loan for less than the full amount owed
- Having part of a loan balance forgiven
- Certain foreclosures and repossessions
- Mortgage debt forgiveness
- Certain student loan discharges
For example, suppose you owe $20,000 on a credit card, and the creditor agrees to accept $12,000 to settle the account. The remaining $8,000 that you no longer have to repay may be considered cancellation of debt income.
However, that doesn’t necessarily mean you’ll owe income tax on the entire $8,000.
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