This article was fact-checked by our editors and Tolla Tu, tax specialist with Credit Karma Tax®.
When you’re struggling to pay your bills, having debt forgiven can seem like a light at the end of a long, dark tunnel. But your canceled debt may still cost you — in the form of federal income tax.
“When the lender walks out the door and closes it behind him, the tax man knocks,” says Riley Adams, a CPA from financial blog Young and the Invested.
That’s because the IRS generally treats forgiven and canceled debts like income. For example, if you settle with your credit card company for $5,000 less than you owe, the IRS views it the same as if your credit card company cut you a check for $5,000.
But all hope isn’t lost — the tax code has a number of exceptions and exclusions to this rule. And even if you do end up owing, you may be able to apply for an IRS payment plan so that you can pay off your tax debt over time.
If you can’t repay your debts, like credit card debt or a personal loan, it’s possible that your lender might agree to settle for less than you owe or forgive your debt entirely. This can bring a welcome sigh of relief — until you get a Form 1099-C in the mail when it’s time to do your taxes.
When qualifying creditors cancel $600 or more of debt for an individual, corporation, partnership, trust, estate, association or company, they must issue a 1099-C, which shows the amount of debt forgiven. Creditors must do this even if the debtor isn’t required to report the amount as income, and they must issue the form for the tax year when the debt was canceled.
“People usually associate tax forms with some kind of exchange of cash,” says Logan Allec, a CPA and owner of the personal finance site Money Done Right. “Either cash they made, like W-2 income or a 1099 for interest, or cash they paid, like a 1098 for mortgage interest or a 1098-E for student loan interest.”
Even though you might not think of your canceled debt as “taxable income,” the IRS may count it that way. And just like any other income, you have to report and pay taxes on it. In this case, the creditor reports that income to the IRS in the form of a Form 1099-C.
What’s the difference between a Form 1099-A and a Form 1099-C?
A 1099-A is used when you a lender forecloses on your house or you abandon your house. A 1099-C is used when you have debt canceled or forgiven.
If your lender agreed to accept less than you owe for a debt, you might get a Form 1099-C in the mail. Alternatively, your lender might automatically discharge the debt and send you a Form 1099-C if it’s decided to stop trying to collect the debt from you.
While lenders are only required to send 1099-Cs if a canceled debt is worth $600 or more, you’re still responsible for reporting smaller amounts of canceled debt as gross income on your federal income tax return. And you may be obligated to pay tax on canceled debt, even if you don’t receive a 1099-C for it.
“Just because you receive that form doesn’t necessarily mean that you’re going to have to pay tax on the canceled debt,” says Allec. “Congress has laid out some exceptions and said, ‘Well, if one of these exceptions applies to you, then you don’t have to pick up this cancellation of debt as income.’”
If you’re lucky enough to qualify for any of these situations, you may still need to file a Form 982 along with your federal tax return. The form explains why your discharged debt should be excluded from your gross income.
If the forgiven debt is a gift
If someone (like a friend or family member) lends you money and later tells you not to worry about repaying them, the IRS considers this type of debt cancellation to be a gift. Your benefactor isn’t required to issue you a Form 1099-C, and you aren’t required to report it as income.
If your total debts (including the forgiven debt) are greater than your total assets then you aren’t required to pay taxes on the canceled debt, up to the amount you’re considered insolvent. You do have to file a Form 982 to qualify for this exclusion.
“Let’s say you have $20,000 of debt, including the forgiven debt, and you have $12,000 of assets,” Allec says. “You’re insolvent by $8,000. But then let’s say you had $10,000 of that total debt forgiven. You can only exclude $8,000 of that debt because that’s the amount you were insolvent.” So you’d still have to pay taxes on $2,000 worth of income.
When you file for Chapter 7 bankruptcy or Chapter 13 bankruptcy, some or all of your debts may be canceled. The IRS doesn’t require you to pay taxes on debt that’s canceled through bankruptcy court or through a plan approved by the court. You’ll need to file a Form 982 with your tax return for this exclusion.
Certain student-loan forgiveness programs
Generally, debt forgiven through student-loan forgiveness programs is also treated as debt income. For example, if the balance of your federal student loans is forgiven while you’re on an income-driven repayment plan, you may still owe taxes on the forgiven amount unless you qualify for another exception.
But if your student-loan balances are forgiven as part of the Public Service Loan Forgiveness program, you won’t have to report that forgiven debt as income. Similarly, with new changes from the Tax Cuts and Jobs Act, if your federal student loans are discharged because you become disabled, you won’t need to include that canceled debt in your income.
Farm and business real-estate debts
Finally, you may not have to pay taxes on certain forgiven debts resulting from your business. If you’re a farmer, earned at least half your income from your farm in the three tax years before the current tax year, and have farm-related debt forgiven by a qualified person, you won’t have to include the canceled farm debt in your income.
Similarly, if you have debt from business real estate canceled, you may not owe any taxes on this either. You’ll need to file a Form 982 for this exclusion. And the exclusion amount may be limited if you also have an insolvency or bankruptcy.
If you’re struggling to pay your bills, debt relief can feel like getting a fresh financial start. But before you can begin rebuilding your finances, it’s important to know whether you’ll owe federal income tax on the forgiven debt.
Regardless of whether you receive a Form 1099-C, you may have to report canceled debt as income, since the IRS generally considers forgiven debt to be taxable income. Under certain circumstances, you may qualify for an exception. But if you do owe tax on forgiven debt, you may be able to apply for a payment plan with the IRS, which could allow you to spread out your repayment over time.
A tax specialist with Credit Karma Tax®, Tolla Tu has international experience in accounting, tax, finance, banking and consulting. She holds a bachelor’s degree in financial management from Beijing University of Chemical Technology, a master’s in corporate finance from Central University of Finance and Economics as well as a Master of Professional Accountancy from Montana State University. You can find her on LinkedIn.