Overview

When a lender cancels, discharges, or forgives part of a loan during or after a refinance, the canceled amount is usually taxable to the borrower as income. In my 15+ years advising borrowers and preparing returns, I’ve repeatedly seen taxpayers surprised by a 1099‑C and an unexpected tax bill. The IRS treats cancellation of debt (COD) as income in most cases (see IRS Topic No. 431) and will typically report it on Form 1099‑C (Cancellation of Debt) when $600 or more is canceled (IRS, Form 1099‑C instructions).

(Source: IRS — Cancellation of Debt and Form 1099‑C: https://www.irs.gov/taxtopics/tc431 and https://www.irs.gov/forms‑pubs/about‑form‑1099‑c)

Why forgiven debt often becomes taxable income

Tax law treats the economic benefit of having an obligation removed as income. Practically, that means:

  • If your lender forgives part of a loan during a refinance or modification, the forgiven amount usually counts as ordinary income. The lender may send a Form 1099‑C showing the amount and the date of cancellation. (IRS Form 1099‑C)
  • The borrower is responsible for reporting the COD income on the federal return unless an exclusion applies and is documented correctly (often with Form 982). (IRS Form 982 instructions)

Exceptions and common exclusions are explained below. Note that state tax treatment may differ, so check state rules or ask a tax pro.

Common exclusions that can make forgiven debt non‑taxable

  1. Bankruptcy discharge
  • Debts discharged in a Title 11 bankruptcy generally are excluded from taxable income. If you received a discharge in bankruptcy, you typically don’t report the canceled debt as income. (IRS, Form 982)
  1. Insolvency
  • If, immediately before the debt discharge, your total liabilities exceeded the fair market value of your assets, you may be insolvent and can exclude some or all of the canceled debt. You must calculate insolvency and attach Form 982 when claiming the exclusion.
  1. Qualified principal residence indebtedness (limited and time‑specific)
  • Historically, the Mortgage Forgiveness Debt Relief Act allowed some homeowners to exclude forgiven mortgage debt used to buy, build, or substantially improve their principal residence. The technical details and effective dates changed over time; for many taxpayers that federal exclusion is no longer broadly available after the statutory period ended. Confirm current applicability for any special programs or temporary extensions before assuming the exclusion applies. (IRS)
  1. Qualified farm debt and certain real property business debt
  • Special rules apply if the debt qualifies under these categories; Form 982 guidance explains how to report. (IRS)
  1. Nonrecourse loan outcomes
  • If a loan is nonrecourse, the lender’s recovery is limited to the collateral. A foreclosure or transfer of the property in satisfaction of a nonrecourse loan generally results in the borrower being treated as having sold the property — not as having received cancellation of debt income. The tax result is usually gain or loss on disposition, not COD income. For recourse loans, borrowers may receive COD income if a lender forgives a deficiency after sale/foreclosure.

(Author note: I always ask clients whether a loan is recourse or nonrecourse — that distinction can change tax outcomes dramatically.)

How cancelled debt is reported and where it shows up on your return

  • Lenders typically file Form 1099‑C and send a copy to the borrower if $600 or more of debt is canceled. Compare the 1099‑C to your records — lenders can make mistakes.
  • If no exclusion applies, the canceled debt is generally reported as ordinary income on your federal Form 1040 (often on the schedule or line for “other income”). Exact line numbers and schedules change over time; follow the current Form 1040 and Schedule instructions or consult a tax professional.
  • If you qualify for an exclusion (insolvency, bankruptcy, etc.), you generally file Form 982 with your return to reduce the amount of COD income you must report.

Helpful IRS resources: Form 1099‑C, Form 982, and Topic No. 431 (Cancellation of Debt).

Practical example

Example A — Recourse mortgage modification

  • John refinances and his lender forgives $30,000 of a second mortgage as part of the deal. The lender issues a 1099‑C for $30,000.
  • If John is not insolvent and the debt is recourse, he must include $30,000 of ordinary income on his return unless an exclusion applies. If he’s insolvent by $10,000 at the moment before cancellation, he can exclude up to that $10,000 and report the remaining $20,000 as income (after completing the insolvency worksheet and filing Form 982).

Example B — Nonrecourse loan foreclosure

  • Lisa has a nonrecourse HELOC and the property is foreclosed. Because the loan is nonrecourse, the foreclosure is treated as a sale of the property — Lisa recognizes gain or loss on the disposition, but she does not receive COD income equal to the deficiency (the lender cannot seek additional recovery). This produces a different tax calculation than a recourse loan forgiveness.

Step‑by‑step actions if you receive notice of forgiven debt after a refinance

  1. Don’t ignore the 1099‑C. Compare it with your loan payoff/settlement documents and lender statements.
  2. Determine whether the loan was recourse or nonrecourse and whether the event was a foreclosure, short sale, modification, or formal cancellation.
  3. Check for exclusions: bankruptcy discharge, insolvency, qualified farm or business debt, or other applicable relief. Document with receipts, statements, and a solvency worksheet.
  4. If you believe you qualify for an exclusion, complete and attach Form 982 to your return and keep copies of all supporting documents.
  5. Estimate the tax impact and set aside funds if you expect tax due — forgiven debt can bump you into a higher tax bracket or trigger other tax consequences (e.g., phaseouts of credits).
  6. Consult a tax professional before filing if the amount is material or the transaction is complex.

(Author’s practice tip: I recommend running a quick “what if” tax estimate when negotiating or accepting a refinance that includes any debt relief. That prevents cash‑flow surprises the following tax season.)

Common mistakes and pitfalls to avoid

  • Assuming a missing 1099‑C means no taxable event. Lenders sometimes don’t issue a 1099‑C; you are still responsible for correct reporting.
  • Failing to check recourse vs nonrecourse status. That legal distinction determines whether you get COD income or a sale/foreclosure tax result.
  • Ignoring state taxes. Some states tax forgiven debt differently than the federal government.
  • Not using Form 982 properly when claiming an exclusion. Incorrect or incomplete documentation can cause delays or audits.

Where to get authoritative, up‑to‑date guidance

Related FinHelp articles

These pages explain refinancing mechanics that often intersect with COD tax issues (e.g., when you cancel a second mortgage or restructure multiple liens).

Final recommendations and disclaimer

If you face forgiven debt after a refinance, document every agreement, review whether the debt is recourse or nonrecourse, and calculate insolvency before assuming liability. Consult a CPA or tax attorney if the amount is material — tax rules for COD are technical and easy to misapply. This article is educational and not individualized tax advice. Contact a licensed tax professional to address your specific facts and the most current tax rules.