There is a catch when it comes to debt cancellation: most of the time, the sum that is canceled is taxable, so you can still be responsible for paying income tax on it.
What does it mean when a debt is canceled?
If a debt is discharged or forgiven for a sum less than what is owed, it is deemed canceled. The canceled debt is the amount that you are no longer required to pay. Foreclosures, repossessions, mortgage modifications, voluntary property transfers to lenders, and property abandonment can all lead to canceled debt.
The lender should send IRS Form 1099-C, Cancellation of Debt, to the IRS along with the canceled debt, which you should receive. Unless you are exempt, the amount of debt that appears as canceled on your 1099-C form is taxable income on your federal tax return.
When banks are required to report canceled debt
A bank that cancels your debt is required to notify the IRS of the transaction. Banks are required by the IRS to record debt cancellations that result from specific “identifiable events.” The most frequent occurrences of these are:
- A debt that was eliminated through bankruptcy
- Additional actions taken by federal or state courts that render a debt void
- The debt collection statute of limitations has expired.
- An amicable resolution with the debtor
- Discontinuation of collecting efforts, regardless of whether they follow their established policy or a choice
A few examples of these events are the cancellation of college loans, credit card debt, and mortgage debt. Unless there is an exemption to the law, you must declare any forgiven debt on Form 1099-C to the federal income tax authorities and pay tax on the amount of the forgiven debt.
Exclusions for individuals: When debt is NOT taxable
- Insolvency
If you can demonstrate that you were bankrupt at the time the obligation was canceled, you are generally exempt from paying taxes on discharged debt. If you have more debts than assets, you are considered insolvent. You most likely qualify if the bank canceled your loan because you were unable to pay your bills.
You, the borrower, had to be insolvent at the very moment the loan was canceled. Informing the IRS that you were insolvent is insufficient; you also need to complete an IRS insolvency worksheet to demonstrate that your obligations exceeded your assets. In most cases, you are required to pay tax on the canceled debt if you were not bankrupt.
- Bankruptcy
If you filed for Chapter 7 or Chapter 13 bankruptcy and these debts were discharged, it indicates that you were insolvent and that you are not required to pay taxes on the debt cancellation. In this case, the canceled debt is not taxable as part of your gross income.
- Qualified principal residence indebtedness
You can deduct debt from your gross income if it was forgiven before January 1, 2026, and the debt was incurred to buy, construct, or significantly improve your primary dwelling. Simply put, the place where you spend the most of your time is your principal residence for tax reasons.
How much tax do you have to pay on cancellation of debt income?
It’s still better to pay taxes on canceled debt rather than the full amount owed! The tax rate on canceled debt is equal to that of regular income. Your tax rate as a taxpayer varies based on your taxable income and tax bracket; it can be anywhere from 10% and 37%. For instance, you might be responsible for income taxes up to $1,500 if you were in the 15% tax bracket and had $10,000 in debt forgiven.
Does student loan forgiveness count as canceled debt?
For the most part, forgiven student loan debt is treated as taxable income. On the other hand, student loan forgiveness was briefly made tax-free by the American Rescue Plan. In order to be eligible for tax-free debt cancellation, the loan forgiveness had to have taken place between January 1, 2021, and December 31, 2025. If nothing changes, canceled student debt will become taxable once more in 2026.
What should I do if I receive a Form 1099-C but i believe the debt cancellation should be exempt?