Quick answer

When a creditor cancels or settles a debt, the amount canceled is usually included in your gross income for federal tax purposes in the year of cancellation, unless you qualify for a legal exclusion. Creditors generally report canceled debt of $600 or more to both you and the IRS on Form 1099‑C. (See IRS Topic 431 and Form 1099‑C instructions.)

Why canceled debt can be taxable

The tax code treats cancellation of debt as income because it leaves you in a better economic position: an unpaid obligation that disappears increases your net worth, the same effect as receiving money. The IRS calls this “cancellation of debt (COD) income” and requires reporting it unless an exclusion applies. (IRS, Topic 431: Canceled Debts.)

Common types of canceled debt and typical outcomes

  • Credit card charge‑offs and negotiated settlements: If a creditor accepts less than the full balance and forgives the remainder, the forgiven portion is generally COD income. The creditor should issue Form 1099‑C when reporting thresholds are met.
  • Mortgage foreclosure, short sale, or deed in lieu: The forgiven deficiency (the difference between what you owed and what the lender received) is usually taxable, unless you qualify for an exclusion such as bankruptcy or insolvency. Note: the temporary principal residence debt exclusion (formerly under the Mortgage Forgiveness Debt Relief Act) expired for discharges after December 31, 2020, unless Congress extends it. Check the IRS page for updates.
  • Student loans: Discharges in certain cases (e.g., total and permanent disability, some public service loan forgiveness programs) may be non‑taxable. Many administrative or programmatic discharges are specifically excluded—verify program rules and IRS guidance.

Forms you’ll likely see

  • Form 1099‑C, Cancellation of Debt: Creditors file this to report canceled debt of $600 or more; you get a copy and the IRS receives one. If you receive a 1099‑C, don’t assume it’s automatically taxable; it merely reports the creditor’s position. (See our primer on Form 1099‑C.)
  • Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness: Use this form to claim an exclusion for COD income when allowed (insolvency, bankruptcy, qualified exclusions). Filing Form 982 reduces certain tax attributes (e.g., NOLs, basis in assets) as required by the tax code. (See IRS Form 982 instructions.)

Useful reading on our site: see the FinHelp guides on “Form 1099‑C: Cancellation of Debt” and “When to Use Form 982 for Canceled Debt and Tax Relief” for step‑by‑step checks and examples.

Key exclusions that may prevent COD income from being taxable

  1. Bankruptcy discharge
  • Debts discharged through a Title 11 bankruptcy are excluded from gross income. You still must show proof and follow Form 982 rules to claim the exclusion.
  1. Insolvency
  • If, immediately before the cancellation, your total liabilities exceeded the fair market value of your assets, you may exclude COD income to the extent of your insolvency. The excluded amount equals the difference between liabilities and assets. You compute this on Form 982 and attach supporting schedules. (IRS Topic 431.)
  1. Qualified exclusions or statutory exceptions
  • Certain discharges are statutorily excluded (e.g., some student loan discharges, some disaster‑related relief). The principal residence exclusion expired for most situations after 2020; confirm current law on the IRS website.

Practical steps when you receive a Form 1099‑C or know a debt was forgiven

  1. Don’t ignore the form. Confirm the reported amount and the date of cancellation. 1099‑C box 2 shows the date of cancellation; that year’s tax return is where it’s reported unless an exclusion applies.
  2. Check exclusions. Run insolvency calculations and determine whether you were in bankruptcy at discharge. If you qualify, prepare Form 982 and attach schedules documenting assets and liabilities.
  3. Keep documentation. Save settlement agreements, bank statements, closing statements for foreclosures/short sales, and communications with the creditor—these support exclusions and the amounts reported.
  4. Consider timing and tax planning. Large COD events can materially change your tax picture; you may need estimated tax payments or adjustments to withholding for the year. In my practice, clients who prepared in advance avoid large underpayment penalties.
  5. File correctly. If no exclusion applies, report COD income on the appropriate line of Form 1040 (for individuals) or the relevant corporate return. If you exclude the income, attach Form 982 and any required schedules.

Example calculations

  • Example 1: Personal loan settlement. You owed $10,000. The lender accepted $6,000 and issued a 1099‑C for $4,000. That $4,000 is COD income unless you can exclude part or all of it (e.g., insolvency of up to the calculated amount).
  • Example 2: Insolvency exclusion. Immediately before cancellation, your liabilities were $80,000 and assets $30,000—insolvency equals $50,000. If $60,000 of debt is forgiven, you can exclude up to $50,000 and must recognize $10,000 as taxable COD income. Support your calculation with a dated assets/liabilities schedule.

Common mistakes I see in practice

  • Treating 1099‑C as the final answer. The creditor’s reporting doesn’t control your tax treatment; you may have a valid exclusion.
  • Failing to compute insolvency correctly or to document asset values and liabilities at the right time.
  • Not filing Form 982 when required, or mis‑allocating attribute reductions (e.g., reducing the wrong tax attribute first).
  • Overlooking state tax rules. Some states follow federal treatment; others treat COD income differently. Check your state tax authority or consult a tax professional.

Special situations worth noting

  • Co‑signed debt: If a debt is canceled for a co‑signer, the tax consequences may differ depending on who was primarily liable. Coordinate reporting and consult a professional.
  • Business debt vs. personal debt: For businesses, canceled business debt is generally included in gross income but may interact with business loss carryforwards, basis calculations, and S‑corporation shareholder bases differently.
  • Disputes over date of cancellation: The date determines the tax year to report COD income. If negotiations are ongoing, the creditor’s decision or a written agreement usually fixes the date.

How to contest or get help

  • If you believe the 1099‑C is incorrect, contact the creditor immediately and request correction. Keep written records of your communications.
  • If you can’t resolve an issue with the creditor, you can attach a statement to your tax return explaining why you’re excluding the amount and keep copies of supporting documents. The IRS may contact you for verification.

Where to get authoritative guidance

Related FinHelp resources

Bottom line

Canceled debt can produce a tax bill, but numerous statutory exclusions and procedural steps may eliminate or reduce that liability. Review any Form 1099‑C carefully, run an insolvency test if needed, file Form 982 when applicable, and keep clear records. For complex cases—large discharges, business debt, or mixed exclusions—consult a qualified tax advisor.

Professional disclaimer: This article is educational only and does not constitute individualized tax advice. For guidance specific to your situation, consult a CPA, enrolled agent, or tax attorney.