Is Borrowed Money Taxable? Canceled Debt Rules
Navigate the tax implications of borrowed money and debt cancellation. Discover when forgiveness leads to taxable income, the key exceptions, and reporting guidelines.
Borrowed money is generally not considered taxable income when it is received, as there is an obligation to repay it. However, if a debt is canceled, forgiven, or discharged for less than the full amount owed, the canceled portion can become taxable income to the borrower. This concept, known as Cancellation of Debt (COD) income, has specific rules and exceptions that determine its taxability.
The General Rule
When an individual borrows money, such as through a personal loan, mortgage, or student loan, the funds received are not considered taxable income. This is because a loan creates a corresponding obligation to repay the borrowed amount. The loan proceeds are viewed as a temporary transfer of funds rather than earned income, like wages or investment gains. Therefore, receiving a loan itself does not trigger a tax liability for the borrower.
This principle applies broadly across various types of loans, including those from banks, credit unions, or even family and friends, as long as there is an obligation for repayment. The fundamental distinction lies in the repayment obligation: if the money must be paid back, it is a debt, not income.
When Borrowed Money Becomes Taxable
Borrowed money can become taxable when the debt is canceled, forgiven, or discharged for an amount less than what was originally owed. This is referred to as Cancellation of Debt (COD) income by the Internal Revenue Service (IRS). When a lender no longer expects full repayment of a debt, the reduced or eliminated amount is treated as income to the borrower.
Common scenarios where COD income can arise include the settlement of credit card debt, mortgage debt forgiveness after a foreclosure or short sale, or certain instances of student loan forgiveness. For example, if a credit card company agrees to accept $5,000 to settle a $7,000 balance, the $2,000 difference constitutes taxable COD income. The IRS considers this amount income.
Exceptions to Taxability of Canceled Debt
Even when debt is canceled, specific IRS exclusions may prevent it from being considered taxable income. One common exclusion applies if the taxpayer is insolvent immediately before the debt cancellation. Insolvency means that an individual’s total liabilities exceed the fair market value of their total assets. The amount of canceled debt that can be excluded from income under this rule is limited to the extent of the taxpayer’s insolvency.
Debt canceled in a Title 11 bankruptcy case is not taxable. This exclusion applies to debts discharged through a formal bankruptcy proceeding, regardless of the amount. Another exclusion, Qualified Principal Residence Indebtedness (QPRI), applies to debt reduced on a taxpayer’s primary home. This includes debt forgiven due to a decline in the home’s value or the homeowner’s financial condition, such as through a short sale or foreclosure, and has a maximum exclusion amount.
Certain types of student loan forgiveness are also not considered taxable income. This includes forgiveness under programs where the loan is canceled based on the borrower working for a specified period in certain professions or for a broad class of employers, such as Public Service Loan Forgiveness (PSLF). Some student loan discharges have also been temporarily excluded from taxation through December 31, 2025, under the American Rescue Plan Act. If a lender cancels a debt as a gift, the canceled amount is not taxable income to the borrower.
Reporting Taxable Canceled Debt
When a debt of $600 or more is canceled, forgiven, or discharged, the lender is required to report this event to the IRS and to the borrower on Form 1099-C, “Cancellation of Debt.” This form details the amount of debt canceled and the date of the cancellation, serving as an informational document for both the taxpayer and the IRS. Even if the canceled amount is less than $600, it is considered taxable income, though a Form 1099-C may not be issued.
Taxpayers who receive a Form 1099-C must report the canceled debt as ordinary income on their federal income tax return. For most nonbusiness debts, this amount is reported on Schedule 1 (Form 1040), Line 8, designated for “Other Income.” If an exclusion from taxability applies, such as insolvency or bankruptcy, the taxpayer must report the exclusion by filing Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness,” with their tax return. This form informs the IRS that the canceled debt meets the requirements for exclusion and helps to accurately reflect the taxpayer’s income.