Overview

When a lender agrees to accept less than the full balance of a private loan or formally cancels part of the debt, the unpaid portion is often treated by the IRS as cancellation-of-debt (COD) income. That COD amount usually increases your taxable income for the year unless you qualify for an exclusion or exception under the Internal Revenue Code (IRC). This article explains how COD works for private loans, how to verify whether you’ll get a Form 1099‑C, common exclusions, how to report excluded amounts, and practical steps to limit tax surprises.

How COD Is Reported and Why It Matters

Lenders commonly report forgiven debt to the IRS on Form 1099‑C, ‘‘Cancellation of Debt.’’ If you receive a 1099‑C, the IRS will expect you to address the amount on your tax return unless an exclusion applies (IRS, Topic No. 431; Form 1099‑C instructions) (https://www.irs.gov/taxtopics/tc431; https://www.irs.gov/forms-pubs/about-form-1099-c).

A simple numeric example:

  • Loan balance before settlement: $50,000
  • Agreed settlement paid by borrower: $30,000
  • Forgiven amount (potential COD): $20,000
    If no exclusion applies, that $20,000 is generally added to taxable income for the year of cancellation and taxed at your ordinary income rates.

Key documents and forms:

Common Exclusions and Exceptions

Several important exclusions can prevent COD from becoming taxable. Three of the most common are:

1) Bankruptcy discharge

  • Debts discharged through bankruptcy under Title 11 are excluded from taxable income. If your debt was discharged in a Chapter 7 or Chapter 13 bankruptcy, you generally do not report the COD as income (IRC §108(a)(1)(A); see IRS guidance and Form 982 instructions).
  • For practical guidance on bankruptcy discharges and limits, see our article: When Bankruptcy Can Discharge a Loan: Limits and Process.

2) Insolvency exclusion

  • If you are insolvent immediately before the cancellation (total liabilities exceed total assets), you can exclude some or all of the cancelled debt from income up to the amount of your insolvency. You must complete the insolvency worksheet in the Form 982 instructions and attach it to your return if you exclude COD on that basis (IRS, Form 982 instructions).

3) Student loan discharge relief (temporary federal rule through 2025)

  • Under the American Rescue Plan Act of 2021, certain discharges of student loan debt are excluded from gross income for federal tax purposes for tax years 2021 through 2025. This relief can apply to some private student loan discharges depending on the facts; consult a tax professional before relying on this exclusion.
  • For more on private student loan discharge expectations, see: Private Student Loan Discharge Options After Bankruptcy: Realistic Expectations.

Other narrower exclusions exist (e.g., qualified farm indebtedness, qualified real property business indebtedness). The rules can be complex—always check the IRS publications listed below.

Differences Between Personal and Business Loan Forgiveness

  • Personal (consumer) debt forgiven is usually COD income to the individual.
  • For business debt forgiven, the COD may affect the business’s taxable income and basis in assets differently and could have additional tax consequences (e.g., reduction of tax attributes). Business owners should work with a CPA because corporate or partnership tax rules can be substantially different.

Step-by-Step Checklist After a Settlement or Forgiveness

  1. Expect a Form 1099‑C if the lender canceled $600 or more (and if the lender meets reporting rules).
  2. Don’t assume the 1099‑C amount is taxable—carefully review the reason for cancellation and your financial position.
  3. Determine eligibility for exclusions (bankruptcy, insolvency, qualified student loan relief, etc.). Use the Form 982 insolvency worksheet when applicable (https://www.irs.gov/forms-pubs/about-form-982).
  4. If excluding COD, attach required documentation and follow Form 982 instructions. Keep copies of lender letters and settlement agreements.
  5. Estimate the tax impact and set aside funds if exclusion doesn’t cover the full amount.
  6. If audited, you’ll need signed settlement agreements, ledgers showing loan balances, and documents supporting insolvency (bank statements, asset appraisals).

Example Calculations and Filing Scenarios

Scenario A: No exclusion

  • Forgiven COD: $20,000
  • Marginal tax rate: 22%
    Tax due on COD = $20,000 × 22% = $4,400 (plus any state income tax where applicable).

Scenario B: Insolvency exclusion

  • Eligible insolvency amount: $15,000
  • COD: $20,000
    Taxable COD = $20,000 − $15,000 = $5,000; tax at marginal rate.
    You must file Form 982 and the insolvency worksheet to claim the exclusion.

Scenario C: Bankruptcy discharge

  • COD from debt discharged in bankruptcy: $20,000
  • Result: Generally not reported as taxable income if properly discharged. Maintain bankruptcy discharge paperwork to show the discharge year and terms.

Practical Negotiation and Tax Planning Tips

  • Negotiate with the tax impact in mind: a lender may accept a structured settlement (installment or balloon payment) that lowers immediate COD and spreads tax consequences.
  • Ask the lender whether they will issue a 1099‑C and the intended date of cancellation—timing can shift the tax year in which COD is reportable.
  • If insolvency appears likely, document asset values and liabilities before settlement; that evidence is critical to substantiate an insolvency exclusion.
  • Consider phasing settlements across tax years if it reduces marginal tax rates or allows using exclusions more effectively—coordinate timing with your tax advisor.

Common Mistakes and How to Avoid Them

  • Assuming forgiveness is always tax-free. Many borrowers mistakenly believe a negotiated reduction won’t trigger taxes; it often will unless an exclusion applies.
  • Failing to report excluded COD properly. Even when excluded, you usually must file Form 982 and retain supporting documentation.
  • Ignoring state tax rules. Some states do not follow federal COD exclusions—check state tax law or consult a state-licensed CPA.

Records to Keep (for at least 3–7 years)

  • Settlement agreement and payoff statements
  • Correspondence with lender about cancellation or settlement
  • Form 1099‑C and lender’s explanation of why debt was cancelled
  • Bankruptcy discharge papers (if applicable)
  • Financial statements and records supporting an insolvency claim

Frequently Asked Practical Questions

  • Will I get a 1099‑C for every settlement? Not always—reporting depends on lender rules and federal reporting thresholds; but expect it when a substantial balance is cancelled.
  • If I’m insolvent, how much is excluded? You can exclude up to the amount your liabilities exceed your assets immediately before the cancellation.
  • What if I disagree with the 1099‑C amount? Contact the lender first. If unresolved, consult a tax professional; keep copies of communications and any corrected forms the lender issues.

Where to Read Official Guidance

Final Recommendations and Professional Disclaimer

If you’re negotiating a private-loan settlement or have had debt forgiven, involve a tax professional early. In my years advising clients, the biggest regret I see is treating the settlement as a purely cash decision and overlooking tax and timing consequences. This article is educational only and not individualized tax advice. For help with a specific situation, consult a qualified CPA, tax attorney, or enrolled agent.

Authoritative and current IRS guidance and forms should be consulted before filing—rules and temporary policy changes (for example, student loan discharge tax treatment) can change over time. Additional context on bankruptcy-related discharges can be found in our glossary entry describing limits and process: When Bankruptcy Can Discharge a Loan: Limits and Process, and for private student loan discharge expectations see: Private Student Loan Discharge Options After Bankruptcy: Realistic Expectations.