What Is a Cancellation of Debt and Is It Taxable?

A cancellation of debt (COD) occurs when a lender forgives all or part of a debt you owe. This means you are no longer legally obligated to repay the full amount, or any portion, of a loan. While receiving debt relief can provide financial breathing room, it often carries tax implications that borrowers need to understand.

Understanding Taxable Debt Cancellation

Canceled debt is generally considered taxable income by the Internal Revenue Service (IRS). When a debt is forgiven, you receive a financial benefit, as you no longer have to repay an obligation. The Internal Revenue Code (IRC) specifically includes discharge of indebtedness in a taxpayer’s gross income. This principle applies whether the debt is related to personal expenses, business operations, or other financial commitments.

When a debt is canceled, the lender is typically required to report the amount of the forgiven debt to both you and the IRS. This reporting is usually done on Form 1099-C, Cancellation of Debt, if the amount is $600 or more. This form notifies the IRS of the canceled debt, and it generally expects this amount to be included in your taxable income unless an exclusion applies.

Common Ways Debt is Canceled

Debt cancellation can arise from various real-world situations, often when a borrower faces financial hardship and a lender agrees to settle for less than the full amount owed. One common scenario involves credit card debt forgiveness or settlements, where a credit card company might agree to accept a reduced payment to close an account. This can happen if a borrower negotiates directly with the creditor or through a debt settlement company.

Foreclosures and repossessions also frequently result in canceled debt. When a lender repossesses a car or forecloses on a home, and the sale proceeds do not cover the outstanding loan balance, the remaining deficiency might be forgiven. Similarly, in a short sale of real estate, the lender agrees to accept a sale price that is less than the mortgage balance, forgiving the difference.

Student loan forgiveness programs can also lead to canceled debt, where criteria allow for some or all of a student loan balance to be discharged. Additionally, debt discharged as part of a bankruptcy proceeding is a form of cancellation, although the tax treatment of this type of cancellation differs.

Situations Where Debt Cancellation is Not Taxable

While canceled debt is generally taxable, several exceptions and exclusions can prevent it from being included in your gross income.

Insolvency

If you are insolvent immediately before the debt cancellation, you may be able to exclude the canceled amount from income up to the extent of your insolvency. Insolvency means your total liabilities exceed the fair market value of your total assets. For example, if your assets are $50,000 and your liabilities are $100,000, you are insolvent by $50,000, and up to $50,000 of canceled debt could be excluded.

Title 11 Bankruptcy Case

Debt discharged in a Title 11 bankruptcy case is another exclusion. If your debt is canceled by the bankruptcy court, the amount is generally not considered taxable income.

Qualified Principal Residence Indebtedness

The Qualified Principal Residence Indebtedness exclusion applies to certain debt canceled on your main home. This provision allows taxpayers to exclude forgiven mortgage debt on their primary residence from taxable income. This exclusion generally applies to debt incurred to acquire, construct, or substantially improve your main home, or to refinance such debt, and has a maximum exclusion amount of $750,000 ($375,000 for married individuals filing separately). Forgiveness of qualified principal residence indebtedness can be excluded from income for discharges occurring before January 1, 2026, or if a written arrangement was made before that date.

Qualified Farm Indebtedness and Qualified Real Property Business Indebtedness

Exclusions also exist for Qualified Farm Indebtedness and Qualified Real Property Business Indebtedness. Qualified farm indebtedness can be excluded if it was incurred in connection with the taxpayer’s farming business, and at least 50% of the taxpayer’s gross receipts for the three preceding tax years were from farming. The debt must also be canceled by a qualified person, such as a commercial lender or government agency.

Qualified real property business indebtedness allows taxpayers, other than C corporations, to elect to exclude canceled debt related to real property used in a trade or business. The debt must be secured by the real property and typically incurred to acquire, construct, or improve the property. Amounts excluded under this provision reduce the basis of the taxpayer’s depreciable real property.

Gift

If the debt cancellation is considered a gift, it is generally not taxable income to the recipient. This applies when the lender forgives the debt out of detached and disinterested generosity, rather than for business reasons.

How to Report Canceled Debt

When a debt of $600 or more is canceled, the lender is typically required to issue Form 1099-C, Cancellation of Debt, to you and the IRS by January 31 of the year following the cancellation. This form reports the amount of debt canceled and the date of cancellation. Review the information on Form 1099-C, and if incorrect, contact the lender for correction.

If the canceled debt is taxable, you must report it as ordinary income on your tax return. For nonbusiness debts, this amount is generally reported on Schedule 1 (Form 1040), line 8c. If the canceled debt relates to a business, it would be reported on the appropriate business income form, such as Schedule C (Form 1040) for a sole proprietorship.

Even if the canceled debt is excluded from your income due to an exception like insolvency or bankruptcy, you still need to report it to the IRS. This is done by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. Form 982 informs the IRS about the exclusion and helps adjust certain tax attributes, such as net operating losses or the basis of property, which may be reduced by the excluded amount. You should attach Form 982 to your federal income tax return for the year in which the debt was canceled.