Tax Consequences of Loan Forgiveness: What to Expect

How cancelled debt becomes taxable

When a lender cancels, forgives, or settles a borrower’s debt for less than the full amount owed, the IRS commonly treats the forgiven amount as taxable income called cancellation of debt (COD) income. Lenders typically report canceled debt to the IRS and to borrowers on Form 1099‑C (Cancellation of Debt). If you receive a 1099‑C, the amount in Box 2 is generally taxable unless a specific exclusion applies. (See IRS guidance on Form 1099‑C and Cancellation of Debt: https://www.irs.gov/forms-pubs/about-form-1099-c.)

Key exceptions where COD income may not be taxable include:

• Discharge of certain student loans under a temporary federal exclusion (student loans discharged between 2021 and 2025 are excluded from gross income under the American Rescue Plan Act of 2021; check the IRS for current dates and rules).
• Discharge of debt in bankruptcy (generally excluded from gross income).
• Insolvency immediately before the discharge (you can exclude COD income up to the amount you were insolvent).
• Certain qualified farm indebtedness or nonrecourse mortgage discharges (specific rules apply).
• Specific program exclusions such as Paycheck Protection Program (PPP) loan forgiveness (for federal tax purposes PPP forgiveness is excluded from gross income under pandemic‑era rules; see SBA/IRS guidance).

Authoritative sources and quick links:

• IRS — Cancellation of Debt (Topic 431) and Form 1099‑C: https://www.irs.gov/taxtopics/tc431 and https://www.irs.gov/forms-pubs/about-form-1099-c
• IRS — Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness): https://www.irs.gov/forms-pubs/about-form-982
• Consumer Financial Protection Bureau — cancellation of debt basics: https://www.consumerfinance.gov

Common scenarios and what to expect

Student loan forgiveness

• Federal student loans discharged under many government programs historically created COD income. However, under the American Rescue Plan Act of 2021, student loan discharges occurring from 2021 through 2025 are excluded from federal gross income. That means federal student loan forgiveness during that window generally will not create federal taxable income. State rules can differ, and the federal exclusion is temporary — check the IRS and your state tax authority for updates.
• For PSLF (Public Service Loan Forgiveness), forgiveness granted during the exclusion window is typically not taxed federally. For practical PSLF details, see our PSLF eligibility checklist: PSLF: Public Service Loan Forgiveness – Eligibility Checklist.

Business loan forgiveness (PPP, EIDL, etc.)

• Paycheck Protection Program (PPP) loan forgiveness is excluded from federal gross income for qualifying borrowers. However, borrowers should review guidance on deducting expenses paid with forgiven PPP funds and consult a tax professional for the latest guidance, as law and IRS interpretation have evolved.
• Other small business loan discharges or EIDL-related relief may have different tax treatments — confirm details with the SBA and IRS.

Mortgage and consumer debt

• Mortgage debt forgiven through short sales, deeds in lieu of foreclosure, or lender workouts can generate COD income. There have been targeted exclusions in the past for principal residence indebtedness; these exclusions change over time and often have limited windows.

Settlement of debt for less than owed

• If you negotiate a settlement and the lender accepts less than the principal balance, the difference generally counts as COD income. For example, if you owe $40,000 and settle for $25,000, the $15,000 forgiven may be taxable.

How to handle a 1099‑C and steps to take

1. Read the 1099‑C carefully. Confirm the amount in Box 2 and the date of identifiable event in Box 4. The lender mails copies to you and the IRS.
2. Determine whether an exclusion applies (bankruptcy, insolvency, qualified programs, etc.).

• To claim insolvency, you must calculate the difference between your liabilities and the fair market value of your assets immediately before the discharge.

1. If an exclusion applies, complete and attach IRS Form 982 to your tax return to report the exclusion and reduce tax attributes accordingly: https://www.irs.gov/forms-pubs/about-form-982.
2. If you can’t exclude the COD income, be prepared for an increase in taxable income and potentially a higher tax bill. Estimate the tax using your marginal tax rate and plan for payment or an installment agreement with the IRS if needed.

Practical example

• You have $30,000 in forgiven debt and no exclusions apply. If your marginal federal rate is 22% and you live in a state with no additional tax, the immediate federal tax would be roughly $6,600. If your state taxes forgiven COD income, add that amount at the applicable state rate. This quick estimate helps you plan cash flow and withholding.

How insolvency and bankruptcy exclusions work (brief)

• Bankruptcy: Debt discharged in a Title 11 bankruptcy is generally excluded from gross income per IRS rules. If your debt is discharged through bankruptcy, you typically do not report that COD as income.
• Insolvency: If your liabilities exceeded the fair market value of your assets immediately before the discharge, you may exclude COD income up to the amount by which you were insolvent. The process requires careful recordkeeping and a completed Form 982.

State tax differences and decoupling

States take different approaches to COD income. Some follow federal treatment and exclusions; others do not — meaning you may owe state tax even when federal law excludes the discharge. Check your state Department of Revenue website or consult a tax professional. For general consumer guidance, the Consumer Financial Protection Bureau provides useful explainers on canceled debt: https://www.consumerfinance.gov.

Tax-planning strategies before and after forgiveness

• Consult a tax professional early: If you’re applying for or offered forgiveness, run a tax projection and explore alternatives (repayment, settlement timing, insolvency analysis) before finalizing the deal.
• Adjust withholding or make estimated tax payments if you expect a larger tax bill.
• Consider timing: In some cases, deferring the year of recognition or coordinating with other deductions or credits can reduce net tax impact, but don’t assume this is possible—get professional advice.
• Keep complete records: payoff letters, settlement agreements, 1099‑C copies, asset and liability statements for insolvency calculations, and documentation of any program eligibility (PSLF paperwork, employer certifications).
• Explore installment agreements or an Offer in Compromise with the IRS if you can’t pay the tax in full.

Mistakes to avoid

• Ignoring a 1099‑C: Receiving a 1099‑C does not automatically mean you owe tax, but failing to address it can create penalties and interest.
• Assuming student loan forgiveness is always taxable: Because of the temporary federal exclusion (2021–2025), many student loan discharges during that window are not taxed federally, but this can change and state rules may differ.
• Missing state tax obligations: Always confirm state treatment.

Related articles and further reading

• For details on how student loan discharges affect taxes, see: Tax Implications of Student Loan Discharge.
• For employer assistance plans and their tax treatment, see: Employer Student Loan Repayment Assistance: How It Works and Tax Considerations.

When to get professional help

If you receive a 1099‑C, have significant assets, or expect a large tax bill from forgiven debt, engage a CPA or tax attorney. In my practice advising clients for over a decade, the most useful step borrowers take is an early consultation so tax consequences are part of the decision to accept forgiveness or pursue alternatives.

Final takeaways

• Forgiven debt often creates COD income, but meaningful exceptions exist (bankruptcy, insolvency, some student loan discharges, PPP forgiveness).
• Don’t assume tax-free: verify program rules, federal exclusions, and state treatment.
• Use Form 982 to claim exclusions and consult authoritative sources (IRS, SBA, CFPB) and a tax professional before you file.

Professional disclaimer: This article is educational and does not replace personalized tax or legal advice. For guidance tailored to your situation, consult a qualified tax professional or attorney. Authoritative resources: IRS (https://www.irs.gov), Consumer Financial Protection Bureau (https://www.consumerfinance.gov), Small Business Administration (https://www.sba.gov).