Bank Forgiveness of Debt: Is It Taxable Income?

When a bank or financial institution forgives a debt, it means the borrower is no longer obligated to repay that amount. This can happen with various types of loans, such as credit cards, personal loans, or mortgages. While this release from a financial obligation provides immediate relief, it can also introduce an unexpected tax consequence. The event of having a debt canceled by a lender requires attention when filing your annual tax return.

The General Tax Rule for Canceled Debt

The Internal Revenue Service (IRS) has a clear stance on forgiven debt: it is generally considered taxable income. This concept is known as Cancellation of Debt (COD) income. The logic behind this rule is that when a lender cancels a debt, the borrower has received an economic benefit equal to the amount you no longer have to repay, and this benefit is treated as income.

This means the forgiven amount must be reported on your tax return for the year the cancellation occurs. For instance, if a credit card company settles a $10,000 balance for a payment of $4,000, the remaining $6,000 that is forgiven becomes COD income. For nonbusiness debts, like personal credit cards, the forgiven amount is reported as “Other Income.”

Understanding Form 1099-C, Cancellation of Debt

When a financial institution or other applicable entity cancels $600 or more of a debt, it is required by the IRS to issue a Form 1099-C, Cancellation of Debt. This form is sent to both the borrower and the IRS, typically by January 31 of the year following the debt cancellation. Its purpose is to officially report the amount of forgiven debt, which the IRS will then look for on your tax return.

The form contains several pieces of information. Box 2 shows the total amount of debt that was discharged, and Box 3 reports any interest that was included in the canceled debt amount. It is important to review Form 1099-C carefully for accuracy as soon as you receive it. If you believe any information is incorrect, you should immediately contact the lender who issued it to request a corrected version.

Common Exclusions for Canceled Debt Income

While the general rule treats canceled debt as income, there are several important exceptions, known as exclusions, that allow you to avoid paying tax on the forgiven amount. The most common of these are related to bankruptcy and insolvency. If a debt is discharged in a Title 11 bankruptcy case, such as a Chapter 7 or Chapter 13 filing, the canceled debt is not considered taxable income.

The insolvency exclusion is another frequently used exception. You are considered insolvent if, at the exact moment before your debt was canceled, the total of all your liabilities was greater than the Fair Market Value (FMV) of all your assets. The amount of forgiven debt you can exclude from income is limited to the amount by which you were insolvent. For example, if you had total liabilities of $70,000 and assets valued at $50,000, you would be insolvent by $20,000. If a lender then forgave a $25,000 debt, you could exclude $20,000 of it from your income, but the remaining $5,000 would still be taxable.

Another exclusion is for Qualified Principal Residence Indebtedness (QPRI). This applies to certain mortgage debt forgiven on a primary home, often in connection with a foreclosure or loan modification. This exclusion is available for debt forgiven through the end of 2025. The maximum amount of forgiven debt that can be excluded is $750,000 for married couples filing jointly, or $375,000 for married individuals filing separately.

How to Report Forgiven Debt to the IRS

The method for reporting forgiven debt depends on whether the amount is taxable or qualifies for an exclusion. If the canceled debt is taxable, you must report the amount shown in Box 2 of Form 1099-C as income on your tax return. For individuals, this is typically done on Schedule 1 of Form 1040, under the “Other Income” line.

If you qualify for an exclusion, such as insolvency or bankruptcy, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your tax return. This form officially notifies the IRS that you are excluding the canceled debt from your income and explains why. You must complete this form even if the exclusion covers the entire amount of forgiven debt, as failing to do so could result in the IRS questioning why the income was not reported.

On Form 982, you will check the box in Part I that corresponds to the reason for the exclusion, such as for a discharge in a Title 11 bankruptcy case or for the insolvency exclusion. If you claim the insolvency exclusion, you must also complete the insolvency worksheet found in IRS Publication 4681 to calculate the extent of your insolvency and keep it with your records.