Quick overview
When a lender cancels, forgives, or discharges debt, the IRS generally treats the canceled amount as “cancellation of debt (COD) income,” taxable to the borrower in the year of discharge. This rule applies to many types of debt — credit cards, personal loans, business loans, and, historically, certain student loans and mortgage debt — unless the law or IRS rules specifically exclude the forgiven amount from income.
Authoritative guidance and further background are available from the IRS (Topic No. 431 on Cancellation of Debt) and the Consumer Financial Protection Bureau’s student loan resources. See: https://www.irs.gov/taxtopics/tc431 and https://www.consumerfinance.gov.
How the tax treatment typically works
Key mechanics you should know:
- Form 1099-C: Lenders commonly report canceled debt of $600 or more to you and the IRS on Form 1099-C, Cancellation of Debt. That form will be a record that you must reconcile on your federal tax return.
- Reporting COD income: Absent an exclusion, report the canceled amount as other income on your Form 1040 for the year the lender issued the 1099-C.
- Form 982: If you qualify for an exclusion (for example, insolvency or bankruptcy), you generally use IRS Form 982 to reduce the COD income on your tax return.
IRS Topic: https://www.irs.gov/taxtopics/tc431 and Form 982 instructions: https://www.irs.gov/forms-pubs/about-form-982
Common exclusions and special rules (what can make forgiven debt non-taxable)
Not every forgiven debt becomes taxable. Important exclusions include:
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Insolvency exclusion (IRC §108): If you were insolvent immediately before the discharge — that is, your total liabilities exceeded the fair market value of your assets — you may exclude canceled debt up to the amount you were insolvent. You’ll need to prove amounts and complete Form 982.
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Bankruptcy: Debt discharged in a Title 11 bankruptcy is generally excluded from income. This is a formal legal discharge; consult an attorney and your tax advisor.
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Statutory or program-specific exclusions: Some federal or state programs specifically exclude forgiven amounts for particular years or circumstances. For example, the American Rescue Plan Act of 2021 temporarily excluded student loan discharge from gross income for tax years 2021 through 2025. Always verify current law and year-specific guidance.
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Business debt exceptions: If a business has cancelled debt and can demonstrate that it resulted in tax attributes adjustments or was related to qualified real property indebtedness, different rules can apply.
Because the availability and scope of these exclusions depend on complex legal definitions and timing, document every financial statement and creditor communication and consult a tax professional before assuming an exclusion applies.
Student loans: evolving rules and the 2021–2025 exclusion
Student loan forgiveness is high-profile and often misunderstood. Historically, most canceled student loan debt was taxable as COD income. However, legislative and administrative actions have changed that landscape at times.
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American Rescue Plan Act (ARPA) of 2021: ARPA included a provision excluding discharged student loan debt from gross income for tax years 2021–2025. That means certain federal discharges during those years are not taxable — but the exclusion is time-limited and subject to the exact terms of the discharge and program. Check the IRS news and guidance for year-by-year implementation details.
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Program rules matter: The tax outcome can differ between Public Service Loan Forgiveness (PSLF), income-driven repayment (IDR) forgiveness, closed-school discharges, or private loan settlements. Read detailed program rules and track whether Congress or the IRS has issued new guidance.
For related coverage on how repayment plans can lead to forgiveness, see our explainer on How Income-Driven Repayment Can Lead to Student Loan Forgiveness (internal link): https://finhelp.io/glossary/how-income-driven-repayment-can-lead-to-student-loan-forgiveness/.
For an in-depth view specifically on post-discharge tax results, see Tax Implications of Forgiven Student Loans After Discharge: https://finhelp.io/glossary/tax-implications-of-forgiven-student-loans-after-discharge/.
Mortgage debt and other consumer debt
Mortgage debt forgiveness historically benefited from special treatment under the Mortgage Forgiveness Debt Relief Act for periods when the exclusion applied to principal residence indebtedness. That specific exclusion has changed over time and has been subject to extensions and expirations. Whether mortgage forgiveness after foreclosure or a short sale is taxable depends on current law and any available exceptions such as insolvency or bankruptcy. Consult the IRS Topic on COD and any recent legislation.
Other consumer debts (credit cards, personal loans, lines of credit) that are forgiven are generally taxable as COD income unless you can use an exclusion like insolvency or bankruptcy.
How lenders and the IRS communicate debt forgiveness
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1099-C timing: Lenders must generally file Form 1099-C for cancelled debt of $600 or more, but timing varies — the discharge year for tax purposes is usually the calendar year the creditor cancels your debt or files the form. Keep records in case the lender’s reporting year and your tax year differ.
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1099-A vs. 1099-C: If the lender acquires an interest in property (for example, a deed-in-lieu of foreclosure), you might receive a Form 1099-A (Acquisition or Abandonment of Secured Property) instead. That form reports the date the lender acquired the property and the outstanding debt; tax consequences differ.
Practical planning steps (what to do if you expect forgiven debt)
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Don’t assume the debt is tax-free. Confirm the legal basis of forgiveness and whether a statutory exclusion applies.
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Save all notices, settlement letters, and the 1099-C or 1099-A you receive. These are necessary for accurate tax reporting.
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Work the math: Project the tax liability. If COD will push you into a higher bracket, calculate potential federal and state tax increases.
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Adjust withholding or make estimated payments: If you’ll owe tax when forgiveness occurs, increase withholding or make quarterly estimated payments to avoid penalties.
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Consider retirement and tax-advantaged contributions: Contributing to an IRA or employer plan may reduce taxable income, but contribution limits and phase-outs apply.
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Check insolvency: If your balance sheet shows liabilities exceeding assets at the time of discharge, work with a CPA to prepare Form 982 and substantiation.
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Consider whether filing an amended return is needed: If lender reporting is corrected later, you may need to amend a previously filed return.
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Seek professional help: When COD amounts are large or involve business tax attributes, engage a CPA or tax attorney. In my practice, large forgiven amounts without planning often led clients to unexpected tax bills; proactive scenarios and cash-flow planning avoid surprises.
Examples (illustrative)
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Example 1 — Credit card settlement: You settle a $20,000 credit card balance for $8,000. The $12,000 forgiven is normally COD income. If you were insolvent by $10,000 at the time of discharge, you could exclude up to $10,000 on Form 982; the remaining $2,000 would typically be taxable.
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Example 2 — Student loan forgiveness in 2023: Under ARPA’s 2021 provision, a federal student loan discharged in 2023 could be excluded from income for tax purposes. Confirm program eligibility and review IRS year-specific guidance before relying on that outcome.
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Example 3 — Mortgage deficiency: After a short sale, if a lender forgives a $25,000 deficiency and no statutory exclusion applies, you may receive a 1099-C and owe tax on that $25,000 unless insolvency or other exceptions apply.
Common mistakes to avoid
- Ignoring a 1099-C or failing to report COD income when required.
- Assuming all student loan discharges are tax-free without verifying the tax year and statutory language.
- Not documenting insolvency before the discharge.
- Failing to adjust withholding or make estimated tax payments when a sizable COD event is expected.
Resources and next steps
- IRS Topic No. 431, Cancellation of Debt: https://www.irs.gov/taxtopics/tc431
- IRS Form 1099-C guidance and instructions: 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 on student loan forgiveness: https://www.consumerfinance.gov
Related FinHelp explainers:
- How Income-Driven Repayment Can Lead to Student Loan Forgiveness: https://finhelp.io/glossary/how-income-driven-repayment-can-lead-to-student-loan-forgiveness/
- Tax Implications of Forgiven Student Loans After Discharge: https://finhelp.io/glossary/tax-implications-of-forgiven-student-loans-after-discharge/
- Student Loan Forgiveness vs. Discharge: https://finhelp.io/glossary/student-loan-forgiveness-vs-discharge/
Professional disclaimer: This article is educational and not personalized tax advice. Tax law changes and individual facts materially affect outcomes; consult a qualified CPA or tax attorney before relying on these examples or making tax decisions.
Authorship note: The analysis and examples reflect practical experience advising clients on COD events and tax planning over 15+ years.
