What happens when you get a cancellation of debt?

Federal student loan forgiveness has been in the news lately, and many business owners may remember having their pandemic relief Paycheck Protection Program loan forgiven by the government.

There are also several other reasons your creditor may forgive your debt in part or in full. For example, a friend or family member may voluntarily forgive your debt in their will or choose not to collect. Likewise, filing for bankruptcy, utilizing business or farm exclusions, cases of death or permanent disability, or a creditor deciding to give up on collecting can all lead to a cancellation of debt (or COD) — a settlement of a debt for less than the amount owed.

Suppose you own property subject to a debt. In that case, cancellation of the debt may occur because of a foreclosure, a repossession, a voluntary transfer of the property to the lender, abandonment of the property, or a mortgage modification.

Generally, the amount of debt forgiven or canceled is still taxable to you. So, if your lender cancels your $10,000 debt, you may still owe taxes on that $10,000, which the IRS treats as gained income.

Furthermore, you may be required to report the canceled debt on your tax return for the year the cancellation occurred.

Having said that, some exceptions can apply in certain circumstances, and your canceled debt’s tax treatment may vary depending on your situation.

How can I avoid paying taxes on a canceled debt?

If you filed for bankruptcy or you were financially insolvent when your lender canceled the debt, you can reduce or eliminate your tax bill for the amount canceled. Likewise, if your debt includes tax-deductible interest, you do not need to report the interest as income since it would have been deductible regardless.

Additionally, suppose a lender takes property that is security for a debt in full or partial satisfaction of the debt. In that case, the transaction is treated as a sale of property, which may result in a gain or loss. Similarly, if the lender then cancels a debt amount over the property’s Full Market Value (FMV), the amount in excess of FMV counts as ordinary income in addition to any gain or loss from the sale. Finally, if the lender cancels the debt as a gift, the amount canceled does not count as income (although gift tax may apply).

Let’s take a more detailed look at some exceptions and exclusions…

Amounts that meet the requirements for any of the following exceptions are not considered income by the IRS:

  • Amounts canceled as gifts, bequests, devises, or inheritances.
  • Certain qualified student loans are canceled under the loan provisions if you work for a certain period in certain professions for a broad class of employers.
  • Certain education loan repayment or loan forgiveness programs that help provide health services in certain areas.
  • Certain student loan discharges after December 31, 2020, and before January 1, 2026.
  • Amounts of canceled debt that would be deductible if you, as a cash basis taxpayer, paid it.
  • A qualified purchase price reduction given by the seller of the property to the buyer.
  • Any amounts discharged from certain federal, private or educational student loans.

The IRS does consider amounts that meet the requirements for any of the following exclusions to be cancelation of debt income. However, such amounts are not included in gross income:

  • Debt canceled in a Title 11 bankruptcy case.
  • Debt canceled to the extent insolvent.
  • Cancellation of qualified farm indebtedness.
  • Cancellation of qualified real property business indebtedness.
  • Cancellation of qualified principal residence indebtedness that is discharged subject to an arrangement that is entered into and evidenced in writing before January 1, 2026.

Generally, suppose you exclude canceled debt from income under one of the above exclusions. In that case, you must reduce specific tax attributes (certain credits and carryovers, losses and carryovers, the basis of assets, etc.) (but not below zero) by the amount excluded. You must attach to your tax return a Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to report the amount qualifying for exclusion and any corresponding reduction of those tax attributes.

How does a 1099-C affect my taxes?

If your lender cancels or forgives a debt of $600 or more, it must provide you with a Form 1099-C, Cancelation of Debt, showing the amount of canceled debt to be reported as income, the date of cancelation, and more.

Never received a Form 1099-C from your lender?

That doesn’t mean you’re off the hook. The lender may have reported the debt cancelation to the IRS themselves, which means if you neglect to report it as well, you could end up with a tax bill or even be audited. Between IRS interest and penalties, you may ultimately pay more than you would have in the first place. That’s why it’s critical to ensure you accurately report canceled debts.

Finally, if you receive a Form 1099-C showing incorrect information, you should contact the creditor to make corrections.

For example, if the creditor continues to collect the debt after sending you the form, they may still need to cancel the debt. As a result, you may not have income in the eyes of the IRS, so be sure to verify your specific situation with the creditor. Your responsibility to report the taxable amount of canceled debt as income on your tax return for the correct year remains the same whether or not you receive a correct Form 1099-C.

Should your canceled debt tax bill be overwhelming, the IRS offers short- and long-term installment payment plans (although both interest charges and penalties apply).

Lastly, if you have already paid taxes on a debt cancelation that you subsequently realize was eligible for an exclusion, you can amend your return for up to three years from the original filing date or two years from the date of payment, whichever is later.

In closing…

The cancelation of debt may seem like an ideal situation on the surface level. While there are undeniable benefits to not having to pay back a lender, it is also essential to understand the tax consequences to avoid the unpleasant surprise of an unexpected bill.

Would you like some help?

If you are a client and would like to book a consultation, call us at +1 (212) 382-3939 or contact us here to set up a time.

If you aren’t a client, why not? We can take care of your accounting, bookkeeping, tax, and CFO needs so that you don’t have to worry about any of them. Interested? Contact us here to set up a no-obligation consultation.


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