Why Is Debt Cancellation Tax-Free? - SmartAsset

Usually, if you have a debt canceled, you will owe taxes on the amount of the canceled debt. The Internal Revenue Service does not consider debt as income unless the debt is canceled. Then the canceled debt is regarded as income and subject to taxation at regular rates. There are some exceptions, however, when you may not owe taxes on canceled debt. These include debt cancellation as a result of bankruptcy, insolvency and possible student loan forgiveness. A financial advisor can help you evaluate whether you owe taxes on canceled debts and help you make a plan if you do.

Debt Cancellation Basics

When you take out a loan, you don’t have to pay income taxes on the proceeds. The IRS does not consider borrowed money to be income. If the creditor cancels the loan, with some exceptions the amount of the forgiveness usually does become income. Then the forgiven debt is subject to taxation at your regular tax rate.

Taxes levied on canceled debt can result in a big surprise tax bill. Lenders are supposed to notify you of canceled debt over a certain amount using a federal tax form, but they may not always do this. And you are still liable for taxes on canceled debt even if you don’t get a notice.

Taxpayers are required to notify the IRS of any canceled debt, including amounts under the minimum for lender reporting and cancellations covered by one of the exclusions. Failing to report or pay taxes on a canceled debt can result in penalties and interest.

Debt Cancellation Tax Exceptions

While most debt cancellations create taxable income, there are some exceptions and exclusions. It’s important to understand how each of those work so that you are prepared for your own debt relief. These exceptions include the following:

If the debt was canceled as part of a bankruptcy case, it’s not counted as taxable income
If you can demonstrate that you are insolvent, you can also avoid paying taxes on canceled debt
Debt canceled as a result of a gift or bequest is exempt from taxes
Businesses with forgiven Paycheck Protection Loans don’t owe taxes on the forgiven amounts
A student loan forgiven for service or due to disability or the borrower’s death is not taxable
A mortgage on a debtor’s principal residence can be modified without creating taxable forgiveness
Some debts owed by businesses and farmers are forgivable tax-free

In some cases, only part of a canceled debt is taxable. For instance, if a borrower has put up collateral that the creditor seizes before canceling the debt, just the amount of the collateral’s fair market value in excess of the canceled debt amount is considered taxable income. Similarly, if a canceled debt includes tax-deductible interest, the amount of the debt equal to the tax-deductible interest can be forgiven tax-free.

Form 1099-C

When a lender forgives a debt valued at more than $600, it usually is required to send the borrower a copy of Form 1099-C. The borrower is required to report this debt on their tax return and, unless it meets one of the exceptions and exclusions, include it as taxable income.

Sometimes a taxpayer with forgiven debt may not receive a 1099-C. Examples include cases when the lender has repossessed collateral or instituted foreclosure proceedings. Also, if the debt is forgiven as part of modifying a loan on a primary residence, the lender may not send a 1099-C.

Reporting Canceled Debt

Even if a taxpayer doesn’t get a 1099-C, it is necessary to report a canceled debt to the IRS. This is reported on the taxpayer’s return. A taxpayer who uses Form 1040, for instance, will report this on Schedule I, which includes additional income and adjustments to income.

Failing to report canceled debt can result in an unpaid tax liability. This can mean having to pay added interest and penalties. On the other hand, sometimes a taxpayer may inadvertently pay taxes on a canceled debt that is covered by one of the exclusions or exceptions. In that case, filing an amended return for the affected tax year can let the taxpayer recoup the extra payments.

The Bottom Line

The canceled debt normally results in taxable income in the amount of debt forgiveness. However, there are some exclusions that can let a taxpayer benefit from debt cancellation without incurring extra taxes. These include cancellations as a result of bankruptcy, insolvency, student loan service programs, principal residence loan modifications and some others. Lenders usually inform taxpayers of canceled debts over $600 with Form 1099-C. Taxpayers must report all canceled debts on their tax returns.

Tips for Debt Cancelation

Consider talking to a financial advisor if you anticipate having debt canceled so you can get a financial plan to help you prepare for that cancellation. If you don’t have a financial advisor then finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
In most cases, your debts won’t be canceled and the only way to eliminate the debt is to pay off the principal and any interest. Use SmartAsset’s free online Credit Card Calculator to calculate how long it will take you to pay off a credit card balance and what the total interest charges will be.