Quick overview

When a lender cancels or forgives a debt, the IRS generally treats the canceled amount as taxable income — called “cancellation of debt” (COD) income. That can turn debt relief into a new tax liability unless you qualify for an exclusion or exception. Authoritative guidance is available from the IRS (see IRS Topic No. 431 and Publication 4681) and the Consumer Financial Protection Bureau (CFPB).

Sources: IRS (Cancellation of Debt) – https://www.irs.gov/taxtopics/tc431; Publication 4681 – https://www.irs.gov/pub/irs-pdf/p4681.pdf; CFPB (debt settlement basics) – https://www.consumerfinance.gov/

How does canceled debt become taxable income?

  • When a creditor forgives $600 or more of your debt, they commonly send Form 1099-C, “Cancellation of Debt,” to both you and the IRS. That form reports the amount the creditor canceled and typically triggers inclusion of the debt in your gross income. (See IRS Form 1099-C information: https://www.irs.gov/forms-pubs/about-form-1099-c.)
  • The canceled amount is generally reported as “other income” on your federal tax return (follow the current Form 1040 and Schedule instructions).
  • Important: a 1099-C is a reporting document created by the lender — it does not itself determine your taxability. You must evaluate whether an exclusion applies before accepting the amount as taxable.

Common statutory exclusions and when they apply

Several rules exclude forgiven debt from taxable income. Key exclusions borrowers should know in 2025:

  1. Student loan discharge exclusion (temporary)
  • The American Rescue Plan Act of 2021 included a temporary exclusion that prevents the inclusion of student-loan forgiveness in taxable income for tax years 2021 through 2025. That means qualifying federal student loan discharges during that period are treated as non-taxable at the federal level. Check the IRS for updates if your discharge occurs in 2025 or later. (IRS guidance and Treasury announcements.)
  1. Bankruptcy discharge
  • Debts discharged in a Title 11 bankruptcy case are excluded from income. If your loan was discharged through bankruptcy, you generally don’t report it as income. See IRS Publication 4681.
  1. Insolvency
  • If, immediately before the discharge, you were insolvent (your total liabilities exceeded total assets), you can exclude the forgiven amount up to the amount you were insolvent. You must calculate insolvency and document it; Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) is typically used to claim the exclusion. See IRS Publication 4681 and Form 982 instructions.
  1. Nonrecourse debt and principal residence rules
  • Nonrecourse loans and certain home mortgage-related exclusions are complex and time-limited. The qualified principal residence indebtedness exclusion has expired and been modified over time; review current IRS guidance for applicability to your situation.
  1. Specific program rules (e.g., PPP)
  • Forgiveness of Paycheck Protection Program (PPP) loans is not treated as taxable income. Moreover, Congress clarified that business expenses paid with forgiven PPP proceeds are deductible for federal tax purposes (see IRS COVID-19 tax relief guidance and Consolidated Appropriations Act updates). Always confirm the specific program rules for your loan type.

Sources: IRS Publication 4681; IRS Form 982 instructions; IRS COVID-19 tax relief updates (irs.gov).

Steps to take when you receive a 1099-C or notice of forgiveness

  1. Don’t panic — read the form completely. Verify the creditor’s information, the reported amount, and the date of cancellation.
  2. Confirm whether you actually owe the reported amount. Lenders sometimes issue 1099-Cs in error or for debts that were previously settled.
  3. Determine whether an exclusion applies (student loan exclusion, bankruptcy, insolvency, etc.). Gather documentation: loan records, settlement agreements, balance sheets showing assets and liabilities, bankruptcy discharge papers, loan servicer letters, or program paperwork.
  4. Use the correct tax forms: typically include the COD amount as other income on Form 1040 unless you can exclude it. If you qualify for insolvency or bankruptcy exclusion, use Form 982 to report the excluded amount and to reduce tax attributes as required.
  5. If the 1099-C is incorrect, contact the creditor and request a corrected form. If unresolved, seek help from a tax professional or the IRS.

Key IRS pages: Form 1099-C instructions (https://www.irs.gov/forms-pubs/about-form-1099-c) and Form 982 instructions (https://www.irs.gov/forms-pubs/about-form-982).

Real-world examples (illustrative)

  • Student loan example: If you had $40,000 in federal student loans and the loan servicer canceled the debt in 2023 under a qualifying federal program, the American Rescue Plan exclusion means you likely don’t report that $40,000 as taxable income for federal taxes for 2023. However, you should keep all program documentation and check state tax rules.

  • Settlement example: You negotiate and settle a $20,000 credit-card balance for $7,000. The creditor issues a 1099-C for $13,000 (the canceled amount). Unless an exclusion applies (for instance, insolvency), you must report the $13,000 as COD income.

  • Business loan example: A small-business owner receives PPP forgiveness. Under current federal law through 2025, PPP forgiveness isn’t treated as taxable income, and related business expenses are deductible for federal purposes. Confirm reporting requirements with your tax preparer.

State tax considerations

Federal exclusions don’t automatically apply to state income tax. Some states may tax canceled debt that the federal government excludes. Always check your state tax agency’s guidance or consult a tax professional licensed in your state.

Common mistakes borrowers make

  • Ignoring a 1099-C or failing to report COD income when required.
  • Filing the 1099-C amount as income without checking available exclusions (insolvency, student loan exclusion, bankruptcy).
  • Assuming all government program forgiveness is tax-free — rules vary by program and by year.
  • Failing to document insolvency calculations or to keep discharge paperwork.

Practical tips and planning strategies

  • Keep thorough records: loan balances, payment history, settlement agreements, and official notices.
  • If you expect large cancellation (e.g., negotiated settlement or loan discharge), plan for potential state tax impacts and possible federal tax liability; set aside funds or arrange withholding/estimated payments.
  • Work with a CPA or tax attorney for complex cases (large balances, business loans, insolvency questions, multi-state filing).
  • If you receive a 1099-C and believe the amount is wrong, act quickly to request correction from the lender and to preserve evidence that supports your position.

Internal FinHelp resources that expand on specific topics:

When to consult a professional

Contact a licensed tax advisor if you receive a 1099-C for a large amount, if you’ve recently completed a bankruptcy, if you’re unsure about insolvency calculations, or if your loan forgiveness involves business tax deductions or multifaceted program rules (PPP, student loan programs, state-level programs). In my experience advising clients, early coordination with a CPA reduces surprises and keeps documentation organized during audits.

Bottom line

Forgiven debt often becomes taxable income, but exceptions (bankruptcy, insolvency, and the temporary student-loan exclusion through 2025) can remove that tax obligation. Treat any 1099-C seriously, gather documentation, and consult a tax professional to determine whether and how to report canceled debt on your tax return.

Disclaimer: This article is educational and does not constitute tax advice. For advice specific to your situation, consult a licensed tax professional or the IRS. Current as of 2025; laws and guidance can change—always confirm with the IRS and your tax advisor.

Authoritative resources