Discharge of Indebtedness Income: Is It Taxable?

When a lender forgives a debt, the borrower gains what is known as discharge of indebtedness income. According to the Internal Revenue Code, this forgiven amount is included in a taxpayer’s gross income for the year the cancellation occurs. The logic behind this is that the borrower has an economic gain; they received funds without the corresponding obligation to repay them. This income is taxed at ordinary income rates, not as a capital gain.

Common Exclusions from Gross Income

An exception to taxing canceled debt applies to debts discharged in a Title 11 bankruptcy case, such as proceedings under Chapter 7 or Chapter 13 of the U.S. Bankruptcy Code. For this exclusion to apply, the debt discharge must be granted by the bankruptcy court or occur as part of a plan approved by the court. The exclusion covers all debts discharged within the bankruptcy proceeding.

Another exclusion is for insolvency. A taxpayer is insolvent when their total liabilities exceed the fair market value (FMV) of their total assets immediately before the debt cancellation. To determine insolvency, one must list the value of all assets and compare that total to all liabilities. The amount of canceled debt that can be excluded from income is limited to the amount by which the taxpayer is insolvent. For instance, if a person has assets of $100,000 and liabilities of $150,000, they are insolvent by $50,000; if a $60,000 debt is canceled, only $50,000 can be excluded, and the remaining $10,000 is taxable income.

The Qualified Principal Residence Indebtedness (QPRI) exclusion addresses forgiven mortgage debt on a primary home. The debt must have been used to buy, build, or substantially improve the principal residence and be secured by that residence. This exclusion applies to debt discharged before January 1, 2026. The maximum amount of forgiven debt that can be excluded is $750,000, or $375,000 for a married individual filing a separate return.

Understanding Form 1099-C

When a creditor cancels a debt of $600 or more, they are required to file Form 1099-C, Cancellation of Debt, with the IRS and send a copy to the borrower. This form reports the details of the debt cancellation. Information on Form 1099-C includes:

• Box 2 shows the total amount of debt that was canceled.
• Box 1 indicates the date of the event that triggered the cancellation, which determines the tax year for reporting.
• Box 3 specifies if any interest was included in the canceled amount.
• Box 6 contains a code that signifies the reason for the cancellation, which can help identify if an exclusion might apply.

Receiving a Form 1099-C does not automatically mean the amount reported is taxable. The taxpayer is responsible for determining if the canceled debt qualifies for an exclusion and reporting the correct amount on their tax return. If information on the form is incorrect, the taxpayer should contact the creditor to have it corrected.

Claiming an Exclusion with Form 982

To claim an exclusion for canceled debt, a taxpayer must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. This form must be attached to the federal income tax return for the year the debt was discharged.

On the form, the taxpayer must check the box in Part I that declares the specific exclusion being claimed. For example, box 1a is for a debt discharged in a bankruptcy case, and box 1b is for the insolvency exclusion.

A consequence of excluding canceled debt from income is the requirement to reduce certain tax attributes. The taxpayer must decrease the value of future tax benefits by the amount of the excluded debt. The reduction is applied in a specific order, starting with any net operating losses (NOLs), followed by certain tax credits, capital loss carryovers, and then the basis of property.

This reduction prevents a taxpayer from receiving a double benefit—both excluding the canceled debt from income and using other tax benefits to lower taxes in the future. For example, if a taxpayer excludes $20,000 of canceled debt due to insolvency and has a $15,000 NOL, they must reduce the NOL to zero. The next available tax attribute is then reduced by the remaining $5,000.

Reporting Taxable Canceled Debt

If canceled debt does not qualify for an exclusion, the forgiven amount must be reported as taxable income. The taxable portion of the canceled debt is reported as “Other Income.”

This amount is entered on Schedule 1 (Form 1040), Additional Income and Adjustments to Income. The taxpayer should locate the line for “Other income” and list the type of income as “cancellation of debt” along with the amount. The total from this line then flows to the main Form 1040. Failing to report taxable canceled debt can lead to an underpayment of tax, which may result in penalties and interest being assessed by the IRS.