Overview

Loan forgiveness means a lender or creditor cancels some or all of the borrower’s obligation to repay a debt. For many kinds of debt, the federal government treats the canceled amount as ordinary income that must be reported on your tax return (often via Form 1099‑C). However, there are important federal exceptions and numerous state-level differences that determine whether you actually owe tax on forgiven debt.

This guide explains the federal baseline, common exceptions, how state laws may diverge, and practical steps you can take to manage or limit tax exposure. It also links to relevant resources and FinHelp articles that help borrowers navigate student loan specifics.

Federal tax treatment: the baseline rules

  • General rule: Cancellation of debt (COD) is includible in gross income under Internal Revenue Code (IRC) §61, and taxpayers normally report COD income in the year the debt is canceled. The IRS explains these rules under its “Cancellation of Debt” topic (see: https://www.irs.gov/taxtopics/tc431).
  • Forms you may receive: Lenders typically report canceled debt to both you and the IRS on Form 1099‑C, Cancellation of Debt (see: https://www.irs.gov/forms-pubs/about-form-1099-c). If you receive a 1099‑C, don’t ignore it—either include the amount as income or document a valid exclusion.
  • Common exclusions at the federal level:
  • Bankruptcy discharge: Debts discharged in bankruptcy are generally not taxable.
  • Insolvency: If you were insolvent (total liabilities exceeded total assets) immediately before the cancellation, you may exclude the canceled amount to the extent of insolvency. The exclusion requires completing IRS Form 982 (see: https://www.irs.gov/forms-pubs/about-form-982).
  • Qualified student loan exclusions: Under the American Rescue Plan Act of 2021, federal student loan discharges of certain loans are excluded from taxable income through December 31, 2025. Confirm the timing and specifics with IRS guidance and your loan servicer as program rules can change.

In practice: I’ve helped clients who assumed a forgiven debt would be tax-free, only to discover a 1099‑C landed in their mailbox. Early identification (and documentation of insolvency or bankruptcy status) often prevents a surprise tax bill.

Why state treatment often differs

States decide whether to conform to federal tax law and, if so, to which version of the Internal Revenue Code they conform. States fall into three broad categories:

  1. States that automatically conform to federal tax code changes.
  2. States that conform, but only as of a specific date (a “fixed date” conformity), which may not include recent federal exclusions.
  3. States that do not conform or that have their own rules for canceled debt.

Because of those differences, a forgiven debt that is excluded from federal income under a recent federal law can still be taxable at the state level. The Tax Foundation and state departments of revenue track these differences—borrowers should verify their state’s current rule before assuming a federal exclusion applies at the state level (see: https://taxfoundation.org/).

Student loans: the most common area of confusion

Student loan forgiveness is a common and high-impact example. Under the American Rescue Plan Act of 2021, certain federal student loan discharges were excluded from federal taxable income for discharges occurring between January 1, 2021 and December 31, 2025. That federal exclusion does not automatically eliminate state tax liability in every jurisdiction.

  • Some states explicitly adopted the federal exclusion.
  • Other states announced temporary guidance or required legislation to conform; a few still tax discharged federal student loan amounts.

For actionable student loan guidance on eligibility and application, see FinHelp’s breakdown of Student Loan Forgiveness Eligibility: Practical Steps to Apply. For documentation and program-specific checklists used in public service programs, see Student Loan Public Service Forgiveness: Documentation Checklist. If you’re evaluating repayment options that impact forgiveness timing, our guide on Income-Driven Repayment Plans: Choosing the Best Fit for Student Loans explains key trade-offs.

Other loan types and special cases

  • Personal loans and credit card debt: Cancellation of these debts is generally taxable federally unless you can claim an exclusion (insolvency, bankruptcy).
  • Business debt: Treatment depends on the type of business entity and whether the debt is nonrecourse or recourse; corporate bankruptcies and business restructurings have distinct rules.
  • Mortgage principal reductions and modification: Historically, the “qualified principal residence indebtedness” exclusion (expired at the end of 2017) once shielded many homeowners. While that specific exclusion is no longer generally available, bankruptcy or insolvency may still apply.
  • SBA loans and PPP forgiveness: Small Business Administration (SBA) loan forgiveness and Paycheck Protection Program (PPP) forgiveness have had their own tax rules and legislative fixes. Consult SBA guidance and IRS updates for current federal and state effects.

Steps to protect yourself and plan ahead

  1. Expect and review Form 1099‑C: If you receive one, don’t assume it’s an error—review the debt, the reason code on the 1099‑C, and whether you qualify for an exclusion.
  2. Check insolvency or bankruptcy exclusions: If you were insolvent immediately before cancellation or the debt was discharged in bankruptcy, you may be able to exclude the amount using Form 982.
  3. Confirm federal exceptions (student loans and other programs): If a federal statute excludes the forgiveness amount, review your timeframe and the statute’s language.
  4. Verify your state’s stance: Check your state Department of Revenue website or consult a tax professional. State rules can lag behind federal law and may require legislative action to adopt newly enacted federal exclusions.
  5. Adjust withholding or make estimated payments: If COD income increases your tax liability for the year, increase withholding or make estimated payments to avoid underpayment penalties.
  6. Document everything: Keep lender notices, settlement agreements, discharge paperwork, and calculations used to support insolvency. Lenders, servicers, and the IRS will expect documentation if you exclude COD income.
  7. Ask for timing alternatives: When possible, negotiate the timing of discharge (for example, defer settlement until early in a year when your income is lower) to minimize marginal tax impact.

In my practice, borrowers who coordinate debt resolution and tax planning with their CPA or tax attorney reduce surprises and sometimes lower overall tax costs by a full tax bracket—especially when insolvency or bankruptcy is involved.

Examples (illustrative)

  • Example A: A borrower with $40,000 in federal student loans receives forgiveness in 2023. Federal law excludes this discharge from taxable income through the American Rescue Plan provisions; however, in a state with fixed-date conformity that does not follow this federal change, the borrower may still owe state tax on the $40,000.
  • Example B: A consumer has $15,000 in credit-card debt canceled by a creditor and receives a 1099‑C. If the consumer’s liabilities exceeded assets immediately before cancellation, the insolvency exclusion can reduce or eliminate taxable income, but the taxpayer must document insolvency and file Form 982.

Practical checklist before you file taxes after forgiveness

  • Did you receive a Form 1099‑C or 1099‑A? Save it.
  • Do you qualify for insolvency or bankruptcy exclusion? Prepare Form 982 and supporting schedules.
  • Does a federal statute exclude this type of debt? Confirm timing and conditions.
  • Has your state adopted the federal exclusion or issued guidance? Check your state revenue site.
  • Talk to a tax professional if the amount is large—unexpected taxable COD can materially change your filing and withholding strategy.

Sources and further reading

Disclaimer

This article is educational and does not constitute legal or tax advice. Laws and IRS guidance change; consult a qualified tax professional, CPA, or attorney for advice specific to your situation.