Is Forgiven Debt Considered Taxable Income?

When a debt is forgiven or canceled for less than the amount owed, it generally has tax implications. Many people assume that if a debt is no longer owed, it simply disappears without further consequence. However, the Internal Revenue Service (IRS) considers forgiven debt as taxable income because the borrower received a financial benefit they are no longer required to repay. While canceled debt is typically taxable, various exceptions and exclusions can prevent it from being included in a taxpayer’s gross income. Understanding these nuances is important for effectively navigating the tax landscape of debt forgiveness.

General Taxability of Forgiven Debt

The IRS refers to the taxation of forgiven debt as “Cancellation of Debt (COD) Income.” The amount of debt canceled for less than owed is considered income because the taxpayer received an economic benefit without full repayment. This is generally subject to income tax. For example, if a credit card company agrees to settle a $10,000 debt for $3,000, the $7,000 difference is typically taxable.

Lenders must report canceled debts of $600 or more to the IRS and the taxpayer on Form 1099-C, Cancellation of Debt. Box 2 of this form indicates the discharged amount, which includes principal, interest, and other non-principal amounts. The form also shows the date of cancellation and a description of the debt. Even without a Form 1099-C, taxpayers must report canceled debt as income if no exclusion applies. Common scenarios generating COD income include credit card debt settlements, personal loan write-offs, or repossessions where a deficiency balance is waived. For instance, if a car is repossessed and the outstanding loan balance exceeds its fair market value, the lender might forgive the remaining deficiency, which is then taxable income.

Common Exclusions from Income

While canceled debt is generally taxable, several specific exclusions allow taxpayers to avoid including the forgiven amount in their gross income. These exclusions are designed to provide relief in particular financial hardship situations or for certain types of debt. Each exclusion has distinct criteria that must be met for the debt to be considered non-taxable.

Insolvency

An exclusion applies if the taxpayer is insolvent immediately before the debt is canceled. Insolvency means total liabilities exceed the fair market value of total assets. To determine this, calculate the fair market value of all assets, including cash, investments, real estate, and personal property, and compare it to total liabilities like mortgages, car loans, and credit card balances.

The excluded amount is limited to the extent of the taxpayer’s insolvency. For example, if $20,000 of debt is canceled but liabilities exceed assets by only $15,000, only $15,000 is excluded, and $5,000 remains taxable. Keep accurate documentation to support an insolvency claim.

Bankruptcy

Debt discharged through a bankruptcy case is generally not taxable income. This applies to both Chapter 7 and Chapter 13 bankruptcies. The rationale for this exclusion is that imposing a tax liability on discharged debt would undermine the “fresh start” principle for individuals in severe financial distress. If a Form 1099-C is received for debt discharged in bankruptcy, taxpayers can use Form 982 to inform the IRS that the amount is excluded.

Qualified Principal Residence Indebtedness (QPRPI)

Debt canceled on a taxpayer’s main home, known as Qualified Principal Residence Indebtedness (QPRPI), can be excluded from income under certain conditions. This applies to debt incurred to acquire, construct, or substantially improve the principal residence. It covers situations like foreclosures, short sales, or loan modifications where mortgage debt is forgiven. The maximum QPRPI excluded is generally $750,000, or $375,000 for married individuals filing separately. This exclusion is available through the end of 2025.

Qualified Farm Indebtedness

Farmers may exclude canceled debt if it qualifies as “qualified farm indebtedness.” This applies to debt incurred directly in connection with farming. Specific criteria include that 50% or more of the taxpayer’s average annual gross receipts for the three preceding tax years must have been from farming. The discharge must also be from a qualified person.

Student Loan Forgiveness

Certain types of student loan forgiveness are not taxable income. This includes forgiveness under programs like Public Service Loan Forgiveness (PSLF) and Teacher Loan Forgiveness, which require work in specific professions or for qualifying organizations. Most federal student loan forgiveness is temporarily tax-free at the federal level for discharges occurring between December 31, 2020, and January 1, 2026. This temporary exclusion applies to various federal student loan programs, including income-driven repayment plans. After 2025, unless extended, some student loan forgiveness may become taxable again.

Debt as a Gift

If a debt is forgiven by a related party, such as a family member, with genuine gift intent, it may be treated as a gift rather than cancellation of debt income. The person forgiving the debt is subject to gift tax rules, not the recipient. For 2025, an individual can gift up to $19,000 per recipient without gift tax reporting. Married couples can collectively give up to $38,000 per recipient. Amounts exceeding this annual exclusion count against the giver’s lifetime gift tax exemption, which is $13.99 million per individual for 2025.

Reporting Forgiven Debt to the IRS

The process of reporting forgiven debt to the IRS involves specific forms, whether the debt is taxable or excluded. Lenders must issue Form 1099-C, Cancellation of Debt, to the taxpayer and IRS if the canceled amount is $600 or more. Even without a Form 1099-C, taxpayers must report canceled debt as income if no exclusion applies.

When forgiven debt qualifies for an exclusion, taxpayers use Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. This form reports excluded amounts and requires identifying the reason for exclusion, such as insolvency or bankruptcy.

Claiming exclusions on Form 982 results in a “reduction of tax attributes.” This means tax benefits like net operating losses, tax credits, or property basis must be reduced by the amount of excluded canceled debt. This adjustment prevents taxpayers from receiving a double benefit—both the exclusion of income and the retention of full tax attributes. For example, if the exclusion is due to qualified principal residence indebtedness, the main home’s basis may need reduction.

If the forgiven debt does not qualify for exclusion, the taxable amount is reported as ordinary income on the federal tax return. For nonbusiness debts, this is typically on Schedule 1 (Form 1040) as “Other Income.” For business debts, it is reported on the applicable business schedule, such as Schedule C.

Maintaining thorough records is important to support claimed exclusions or accurately report taxable canceled debt. This includes retaining copies of Form 1099-C, bankruptcy documents, proof of insolvency (such as balance sheets detailing assets and liabilities), and loan modification agreements. These records provide evidence to substantiate the taxpayer’s position in case of an IRS inquiry. Seeking advice from a qualified tax professional is often prudent due to the complexities involved.