Overview

When a lender cancels or discharges your debt, the IRS generally treats the forgiven amount as income — called cancellation of debt (COD) income. The IRS views the borrower as economically better off because the obligation that reduced the borrower’s net worth is removed. That can create a taxable event even when you never received cash.

This guide explains the rules (current as of 2025), the most common exceptions, how to report forgiven debt, practical examples, and steps to minimize tax surprises. It references IRS guidance and consumer protection resources so you can follow authoritative sources.

Sources used in this article include the IRS “Cancellation of Debt” guidance and Form 982 instructions (IRS.gov) and consumer-oriented information from the Consumer Financial Protection Bureau (CFPB). This is general information and not personalized tax advice—consult a tax professional for decisions about your situation.

How canceled debt becomes taxable income

  • Legal basis: Under Internal Revenue Code (IRC) Section 61(a), gross income includes income from discharge of indebtedness unless a specific exclusion applies. The IRS discusses the topic on its “Cancellation of Debt” page and in Form 982 instructions (see IRS.gov/cancellation-of-debt and Form 982 guidance).
  • Typical forms: Lenders commonly report canceled debt on Form 1099-C (Cancellation of Debt). Receiving a 1099-C is a strong signal that the IRS will expect you to address the amount on your tax return.

Key point: the taxable amount is generally the principal amount canceled, less any amounts the borrower had included on prior returns (rare) and any applicable exclusions or reductions.

Common exclusions and exceptions

Several exclusions prevent canceled debt from being included in taxable income. The most commonly used are:

  1. Insolvency exclusion
  • Legal reference: IRC §108(a)(1)(B).
  • What it means: If you were insolvent (liabilities exceeded assets) immediately before the cancellation, you can exclude the canceled amount to the extent of your insolvency. You must compute insolvency and attach the worksheet to your tax return when claiming the exclusion (see IRS Form 982 instructions).
  • Practical tip: Maintain careful balance-sheet documentation (bank statements, loan statements, asset appraisals) to prove insolvency if audited.
  1. Bankruptcy discharge
  • A debt discharged in a Title 11 bankruptcy is generally excluded from income. If bankruptcy discharged the debt, you usually do not report it as taxable income.
  1. Qualified principal residence indebtedness (QPRI)
  • Historically allowed exclusion for mortgage debt forgiven in certain circumstances. Protections have changed over time; consult current IRS guidance because statutory extensions have varied.
  1. Certain student loan exceptions
  • Federal student loans: Under the American Rescue Plan Act of 2021 and subsequent extensions through 2025, many federal student loan discharges are excluded from gross income — check the IRS and Education Department guidance for current limits and program specifics.
  • Private student loans: Generally treated as canceled debt and may be taxable unless another exclusion (like insolvency) applies. The CFPB provides consumer-facing guidance on student loan forgiveness and likely tax consequences.
  1. Gift or inheritance
  • If the canceled debt is treated as a gift by the lender (rare) or is discharged because of an inheritance situation, different tax rules may apply. The borrower should document the lender’s intent.
  1. Certain pandemic-era programs (PPP)
  • Paycheck Protection Program (PPP) loans: Forgiven PPP amounts were excluded from gross income under the CARES Act and subsequent guidance and legislation. The tax treatment was updated during 2020–2021; current rules exclude forgiven PPP amounts from taxable income. (See IRS and Treasury guidance for details.)

Always confirm the specific program rules: law changes, temporary relief measures, and court rulings can change tax treatment. See IRS “Cancellation of Debt” and program-specific guidance (e.g., Department of Education or Treasury) for authoritative updates.

How to determine taxable amount — worked examples

Example 1 — Credit-card settlement

  • You owed $20,000 on a credit card but negotiated a settlement and the issuer accepted $8,000. The canceled amount is $12,000.
  • If you are not insolvent and no other exclusion applies, you generally report $12,000 as COD income on your federal return for the year of cancellation.
  • Tax effect: The actual tax due depends on your marginal tax rate and other income. At a 22% marginal rate, the tax on $12,000 would be about $2,640 (plus any state tax).

Example 2 — Mortgage short sale and insolvency

  • You had a $300,000 mortgage, sold the home in a short sale for $220,000, and the lender canceled the $80,000 deficiency.
  • If you were insolvent before the cancellation to the extent of $50,000, you can exclude $50,000 of the $80,000. The remaining $30,000 is COD income.
  • Reporting: Use Form 982 and attach required insolvency documentation.

Example 3 — Private student loan discharge

  • $40,000 private student loan discharged and you are solvent. Unless another exclusion applies, you would generally report $40,000 as income and owe tax accordingly. Federal student loan discharges during certain periods may be tax-free — verify program and timing.

Reporting canceled debt: Form 1099-C and Form 982

  • Form 1099-C: Lenders often issue IRS Form 1099-C when they cancel $600 or more in debt. Compare the 1099-C to your own records; lenders sometimes report amounts the borrower is disputing. You must address the 1099-C on your return even if you think the debt was reported incorrectly — but you can attach an explanation and supporting documents.
  • Form 982: If you qualify for an exclusion (insolvency, bankruptcy, etc.), you use IRS Form 982 to reduce the amount of cancellation reported on your return. Form 982 requires that you explain the reason for the exclusion and include any required computation of insolvency.

Practical steps when you receive a 1099-C:

  1. Don’t ignore it—address the amount on your return.
  2. Verify accuracy — confirm the canceled amount and date.
  3. Compute insolvency (if applicable) using IRS worksheets; save documentation.
  4. File Form 982 if claiming an exclusion and attach supporting materials.
  5. If disputed, review the creditor’s reporting and consider contacting the creditor or a tax advisor.

State tax issues

States may treat canceled debt differently than the federal government. Some states conform to federal exclusions; others do not and will tax COD income even if excluded federally. Check your state tax authority or consult your tax advisor to determine whether you could owe state income tax on forgiven debt.

Avoiding tax surprises — planning and best practices

  • Anticipate taxes: When entering into debt-relief negotiations or applying for forgiveness, plan for potential tax consequences. If cancellation is likely, set aside funds or increase withholding/estimated payments.
  • Timing: In limited situations you may be able to time transactions or accelerate/ defer recognition of income—discuss options with a tax pro before taking action.
  • Documentation: Keep records of old loan balances, cancellation letters, settlement agreements, proof of insolvency, bankruptcy orders, and any lender communications.
  • Professional help: A CPA or tax attorney can run insolvency calculations correctly and advise whether a proposed settlement will generate a taxable event.
  • Watch for 1099-C: Lenders must file 1099-C in many cancellations. If you don’t receive one but the debt was canceled, you are still responsible for correct reporting.

Internal resources on related topics

Frequently asked questions

Q: Will I always get a Form 1099-C?
A: Not always. Lenders typically file Form 1099-C for many types of canceled debt, but reporting rules and thresholds vary. Even without a 1099-C, you are responsible for correct reporting.

Q: Are all student loan discharges tax-free?
A: No. Federal student loan discharges have been excluded from federal income through legislative action for certain periods (see Department of Education and IRS guidance). Private student loan discharges are usually taxable unless another exclusion (like insolvency) applies.

Q: What if my lender reports a larger amount than I think they canceled?
A: Compare lender records, contact the creditor to correct obvious errors, and keep correspondence. If unresolved, attach an explanation and supporting documents to your return and consult a tax professional.

Q: Can I deduct settled debt instead of reporting it as income?
A: No. You generally report canceled debt as income unless an exclusion applies; settlement amounts you paid reduce the canceled portion. Debt settlement expenses are not deductible as ordinary business or personal deductions in most cases.

Steps to take right now if you experienced forgiveness this year

  1. Gather documents: 1099-C, settlement letters, loan statements, bankruptcy discharge, foreclosure documentation, and any lender correspondence.
  2. Estimate tax: Use your marginal tax rate to estimate the additional tax. Don’t forget potential state tax.
  3. Consider increased withholding or estimated tax payments to avoid underpayment penalties.
  4. Meet with a tax professional early—complex exclusions like insolvency require accurate calculations and documentation.

Bottom line

Loan forgiveness can provide critical relief, but in many situations it triggers taxable income. Understanding key exclusions (insolvency, bankruptcy, and program-specific rules for student loans and pandemic-era relief) and the mechanics of reporting (Form 1099-C and Form 982) reduces the risk of an unexpected tax bill. Keep thorough records, verify lender reporting, and consult a tax professional for personalized guidance.

Sources and further reading

  • IRS, “Cancellation of Debt (COD),” https://www.irs.gov/taxtopics/tc431 and Form 982 instructions (search “IRS Form 982” on IRS.gov).
  • U.S. Department of Education and IRS guidance on student loan forgiveness (see official sites for program-specific updates).
  • Consumer Financial Protection Bureau (CFPB), “Student Loan Forgiveness Programs,” https://www.consumerfinance.gov.

Professional disclaimer: This article is educational and not individualized tax advice. For guidance about your specific situation, consult a qualified tax professional or attorney.