Are Loans Taxable? When Forgiven Debt Becomes Income

The Concept of Canceled Debt Income

When a lender forgives a debt, the Internal Revenue Service (IRS) considers the forgiven amount as Cancellation of Debt (COD) income. This is because the borrower is now free from the obligation to repay, resulting in an increase in their net worth. The forgiven debt is treated as income for tax purposes in the year the cancellation occurs.

Consider a scenario where an individual has a $10,000 credit card balance. After negotiations, the credit card company agrees to accept a $4,000 payment to settle the entire debt. The remaining $6,000 that the borrower no longer has to pay is considered COD income. This amount must be reported on the borrower’s tax return.

This principle applies to various forms of debt, including credit card balances, personal loans, and other financial obligations where a lender cancels the debt for less than the full amount owed. The core idea is that the forgiven portion represents an economic benefit to the borrower.

Exclusions from Canceled Debt Income

While the general rule treats canceled debt as income, several exceptions can relieve a taxpayer from this liability. One exclusion applies to debts discharged in a Title 11 bankruptcy case. If a debt is canceled as part of a bankruptcy proceeding, the forgiven amount is not considered taxable income, providing a fresh start for the filer.

Another exclusion is for insolvency. A taxpayer is considered insolvent when their total liabilities (debts) are greater than the fair market value of their total assets immediately before the debt cancellation. To determine insolvency, one must list all assets, such as cash, property, and investments, and subtract all liabilities, including mortgages, loans, and other debts. If the liabilities exceed the assets, the taxpayer is insolvent.

The amount of canceled debt that can be excluded from income under the insolvency rule is limited to the amount by which the taxpayer is insolvent. For example, if a person has assets worth $50,000 and liabilities of $75,000, they are insolvent by $25,000. If a lender then cancels a $30,000 debt, only $25,000 of that canceled debt can be excluded from income; the remaining $5,000 would be reported as taxable income.

A third exclusion relates to qualified principal residence indebtedness. This temporary provision allows taxpayers to exclude canceled mortgage debt on their primary residence from their income, often in cases of a mortgage modification, foreclosure, or short sale. Forgiven debt up to $750,000 ($375,000 if married and filing separately) can be excluded. However, this exclusion is scheduled to expire at the end of 2025.

Tax Treatment of Specific Forgiven Loans

The tax rules for forgiven debt can vary depending on the type of loan. While certain programs like Public Service Loan Forgiveness (PSLF) are permanently tax-free at the federal level, a broader, temporary provision has made most other student loan forgiveness exempt from federal income tax. This rule, which applies to discharges occurring through the end of 2025, covers loans from the federal government, educational institutions, and private lenders for postsecondary education.

The nature of a loan, particularly between family or friends, can also affect its tax treatment. If there was no genuine intent for repayment from the beginning, the IRS might reclassify the transaction as a gift rather than a loan. Factors like a written loan agreement and a stated interest rate can help establish the transaction as a true loan.

Required Tax Forms and Reporting

When a lender cancels a debt of $600 or more, they are required to issue Form 1099-C, Cancellation of Debt, to both the borrower and the IRS. This form details the amount of debt forgiven and the date of the cancellation. Receiving a Form 1099-C is a clear indicator that the IRS has been notified of the canceled debt and that the amount may need to be reported on your tax return as income.

To claim one of the exclusions, such as insolvency or bankruptcy, the taxpayer must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with their federal income tax return. This form is not for calculating the exclusion itself but for officially reporting to the IRS that you qualify for one. For the insolvency exclusion, you will need the asset and liability calculations you performed to prove you were insolvent at the time of the debt cancellation.