Is Debt Tax Free? The Facts on Canceled Debt Income
Receiving a loan isn't a taxable event, but debt forgiveness often is. Learn the fundamental tax rules for canceled debt and when it might be excluded.
When you borrow money, the funds you receive are not immediately subject to income tax. This is because the cash comes with a corresponding legal obligation to pay it back. The transaction does not increase your net worth, so it is not considered income by the Internal Revenue Service (IRS). This principle applies whether you are taking out a large mortgage for a home, financing a car, or receiving a personal loan.
The Tax Treatment of Loan Proceeds
The reason loan proceeds are not taxed is based on an accounting principle. When you receive loan funds, your assets increase by the amount of cash received, but your liabilities also increase by the exact same amount. This leaves your net worth unchanged. The IRS defines income as an accession to wealth, and since a loan does not make you wealthier, it does not fit this definition. The legal requirement to repay prevents the funds from being classified as income.
Canceled Debt as Taxable Income
The tax-free nature of a loan changes if the lender forgives or cancels the debt for less than the original amount owed. When a lender discharges your obligation to repay, the forgiven amount is considered Cancellation of Debt (COD) income. This amount is taxable because your liabilities have been reduced without a corresponding decrease in your assets, thus increasing your net worth.
If the amount of canceled debt is $600 or more, the lender will issue a Form 1099-C, Cancellation of Debt. For instance, if you have a credit card balance of $10,000 and the company accepts $3,000 as payment in full, the remaining $7,000 is canceled. The company would issue a Form 1099-C for $7,000, which is taxable income you must report unless an exclusion applies.
Common Exclusions for Canceled Debt
While canceled debt is treated as income, several exclusions may allow you to avoid paying taxes on it. The most common of these are related to bankruptcy, insolvency, and qualified principal residence indebtedness.
A discharge of debt in a Title 11 bankruptcy case, such as a Chapter 7 or Chapter 13 filing, is not considered taxable income. This exclusion takes precedence over others; if a debt is canceled as part of a bankruptcy proceeding, the bankruptcy exclusion applies even if you also qualify for the insolvency or another exclusion.
One of the most frequently used exclusions is for insolvency. You are considered insolvent when your total liabilities are greater than the fair market value of your total assets immediately before the debt was canceled. You can exclude COD income to the extent that you are insolvent. For example, if you have assets worth $40,000 and liabilities of $65,000, you are insolvent by $25,000. If a creditor cancels a $30,000 debt, you can exclude $25,000 of that canceled debt, but the remaining $5,000 would still be taxable.
Another exclusion applies to qualified principal residence indebtedness. This allows homeowners to exclude canceled mortgage debt on their main home. This provision is available through 2025 and is limited to $750,000 of forgiven debt, or $375,000 for a married individual filing separately. The debt must have been used to buy, build, or substantially improve your principal residence.
Additionally, the tax treatment of canceled student loan debt has specific rules. Through the end of 2025, a temporary provision makes the discharge of most federal and private student loans non-taxable for federal income tax purposes. Separately, some forgiveness programs, such as Public Service Loan Forgiveness (PSLF), are permanently non-taxable.
How to Report Canceled Debt on Your Tax Return
Properly reporting canceled debt on your tax return depends on whether the amount is taxable or excludable. If you have determined that the canceled debt is taxable income, you must report the amount from Box 2 of your Form 1099-C on your tax return. For most individuals, this is reported as “Other income” on Schedule 1 of Form 1040.
If you qualify for an exclusion, you are not required to include the forgiven debt in your income. However, you must still file a specific form to claim the exclusion. You must complete and attach IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to your tax return. On this form, you will check the box that corresponds to the specific exclusion you are claiming. Using an exclusion requires you to reduce certain tax attributes, such as your basis in property, which can have future tax consequences.