Overview

When a lender cancels, forgives, or discharges a debt you owe, the IRS generally considers the forgiven amount to be taxable income. That means a relief you welcome financially may create a tax bill the following year. The most common trigger for reporting forgiven debt is Form 1099‑C, “Cancellation of Debt,” which lenders send to both the borrower and the IRS for most discharges of $600 or more. (See IRS Tax Topic 456: Cancellation of Debt.)

This article explains when forgiven debt is taxable, common exclusions, how the reporting process works, ways to reduce or avoid tax on forgiven amounts, and practical steps to prepare ahead. The guidance that follows is general and based on IRS rules current as of 2025; consult a tax professional for advice tailored to your situation.

Sources: IRS Tax Topic 456 (Cancellation of Debt), IRS Form 1099‑C, Consumer Financial Protection Bureau (CFPB) on loan forgiveness.

How forgiven debt becomes taxable

  • Lender reports the canceled amount to the IRS on Form 1099‑C. The lender also sends you a copy.
  • The amount reported is generally treated as “other income” and must be included on your federal tax return for the year the debt is canceled.
  • If you include the amount, it increases your gross income and could boost your adjusted gross income (AGI), which affects tax rates, credits, deductions, and eligibility for other tax benefits.

Key IRS references: Form 1099‑C instructions and Tax Topic 456. If you believe a 1099‑C is incorrect, don’t ignore it — get documentation and talk to a tax professional before filing.

Common exceptions and exclusions (when forgiven debt is not taxable)

The law provides several important exceptions under Internal Revenue Code Section 108 and related rules. The most frequently used exclusions are:

  1. Bankruptcy discharge
  • Debt discharged in bankruptcy is not taxable. You still must attach appropriate documents and follow IRS instructions when you file.
  1. Insolvency
  • If you were insolvent immediately before the discharge (your liabilities exceeded your assets), you may exclude some or all of the canceled debt. You use Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness,” to report the exclusion and calculate the exempt amount.
  1. Qualified farm indebtedness
  • Certain farm debts canceled by a lender may be excluded if the taxpayer meets statutory requirements.
  1. Qualified real property business indebtedness
  • Business debt tied to real property may qualify for exclusion under limited conditions.
  1. Student loans
  • The American Rescue Plan Act of 2021 made any student loan discharge tax-free through December 31, 2025 for federal and certain commercial student loans discharged by the Department of Education. Check current law and Department of Education guidance for updates beyond 2025.
  1. Other statutory exclusions
  • A few other narrow exclusions exist, such as some types of qualified principal residence indebtedness during periods when Congress authorized that exclusion. Always verify current rules because exclusions have been extended, modified, or allowed to expire at different times.

IRS guidance provides step-by-step tests for insolvency and other exceptions; see Tax Topic 456 and Form 982 instructions for details.

Typical scenarios and whether tax usually applies

  • Federal student loan forgiveness under authorized programs (income-driven repayment forgiveness, Public Service Loan Forgiveness, targeted discharges): generally tax-free while the ARPA tax exclusion remains in effect through 2025, but this could change with new legislation. See the Department of Education and IRS guidance.

  • Private student loan forgiveness: often treated differently than federal forgiveness. Private lenders may report discharge on Form 1099‑C unless a specific exclusion applies.

  • Mortgage modifications or principal reductions (short sales, foreclosure deficiency judgments): amounts forgiven in connection with the sale or transfer of your home may be reportable as income; however, special rules have applied in the past for qualified principal residence indebtedness. Always check current law and the settlement documents.

  • Credit card or personal loan settlements: normally taxable. When you settle for less than full balance and the creditor cancels the remainder, expect a 1099‑C and possible tax consequences.

  • Business loan forgiveness (including some SBA EIDL adjustments): generally taxable to the business unless a separate exclusion or an offsetting deduction reduces taxable income. PPP loans were treated as non-taxable and eligible for business deduction treatment based on later statutory clarifications; always confirm the specific loan program rules.

Practical example

A small business owner had $50,000 of debt canceled by a lender. The lender issued Form 1099‑C for the full $50,000. If the business was solvent and no specific exclusion applied, that $50,000 would typically increase taxable income, potentially moving the taxpayer into a higher tax bracket and creating additional federal (and possibly state) tax liability. If the business qualified as insolvent for some or all of the amount, the owner would attach Form 982 and exclude the insolvent portion.

How to respond if you receive Form 1099‑C

  1. Review the form for accuracy: confirm the amount, debtor information, and date of discharge are correct.
  2. Gather documentation: settlement agreements, payoff letters, letters from your lender, and your balance history.
  3. Determine whether you qualify for an exclusion: bankruptcy records, balance sheets showing insolvency, or documentation of qualified farm/business debt.
  4. Use Form 982 to claim exclusions where applicable. If you claim insolvency, you’ll need to complete the insolvency worksheet in the Form 982 instructions.
  5. File your return correctly: report the discharge as income or attach Form 982 and supporting documents if excluding the amount.
  6. If you disagree with the 1099‑C, contact the creditor immediately. If that doesn’t resolve it, consult a tax pro about contacting the IRS.

State tax considerations

State tax treatment of canceled debt varies widely. Some states follow federal treatment and exclude the canceled debt if it’s excluded federally; others tax canceled debt even when it’s non‑taxable at the federal level. Check your state’s department of revenue guidance or ask your CPA.

Planning strategies to limit surprise tax bills

  • Anticipate the tax side when negotiating a settlement: if you’re settling debt, negotiate for a lower reported amount or confirm how the creditor will issue tax reporting.
  • Set aside funds: if debt forgiveness looks likely, reserve money to cover any tax liability until you determine whether an exclusion applies.
  • Time transactions: where possible, time a discharge for a tax year when your income is lower.
  • Use insolvency tests carefully and document thoroughly: insolvency can reduce or eliminate the tax but requires careful calculation and proof.
  • Consult specialists: insolvency, bankruptcy discharges, and business debt rules can be complex—talk to a CPA or tax attorney.

Related resources on FinHelp

These pages explain program rules that affect whether forgiveness will be reported and how it may be treated for taxes.

Common mistakes to avoid

  • Ignoring a 1099‑C or other IRS notices: silence doesn’t make tax obligations disappear.
  • Failing to check state tax rules: state tax bills can surprise borrowers after a federal exclusion.
  • Assuming all student loan forgiveness is tax‑free: the federal exclusion provided by ARPA applies through 2025; changes in law could change that prospect.
  • Not getting professional help for complex cases: insolvency calculations, business debt exclusions, and bankruptcy discharges require documentation.

Final checklist before filing

  • Do you have a copy of Form 1099‑C? Is it accurate?
  • Have you evaluated insolvency or bankruptcy exclusions with supporting proof?
  • Did you consult Form 982 instructions if excluding the discharge amount?
  • Have you checked state tax treatment and potential state filings?
  • Have you discussed your situation with a CPA or tax professional?

Disclaimer

This article is educational only and does not constitute personalized tax or legal advice. Tax law changes frequently; for guidance that reflects your full financial picture, consult a qualified CPA, enrolled agent, or tax attorney.

Authoritative sources and further reading

(For the latest changes to student loan tax treatment, check Department of Education announcements and current IRS guidance.)