What Is Cancellation of Debt and Is It Taxable?

Cancellation of debt (COD) occurs when a lender forgives or discharges a portion or all of a borrower’s outstanding debt. Understanding the tax implications of debt cancellation is important.

Defining Cancellation of Debt

Cancellation of debt occurs when a creditor releases a borrower from the obligation to repay an amount owed. This can happen in various scenarios, such as debt settlements where a borrower negotiates to pay a reduced sum.

Other situations leading to debt cancellation involve foreclosure on a property, repossession of an asset, or debt discharge through bankruptcy proceedings. In these cases, the amount of debt no longer required to be paid is considered the “canceled debt.”

General Taxability of Canceled Debt

The Internal Revenue Service (IRS) generally views canceled debt as taxable income. When a debt is forgiven, the borrower receives an economic benefit, as they no longer have the obligation to repay that money. The funds were not taxed initially because of the repayment agreement; when that obligation is removed, the amount effectively becomes income.

Unless a specific exception or exclusion applies, the canceled debt must be reported as ordinary income on a taxpayer’s federal income tax return for the year the cancellation occurred. This rule applies to most debt types, including credit card debt, personal loans, and mortgage debt.

Exceptions to Taxable Canceled Debt

While canceled debt is generally taxable, several provisions allow taxpayers to exclude certain amounts from their gross income.

Insolvency

One common exclusion applies if the taxpayer was insolvent immediately before the debt was canceled. Insolvency means a taxpayer’s total liabilities exceeded the fair market value of their total assets. The amount of canceled debt that can be excluded is limited to the extent of the taxpayer’s insolvency. For instance, if $10,000 of debt is canceled but the taxpayer was only insolvent by $7,000, only $7,000 can be excluded, leaving $3,000 as taxable income.

Bankruptcy

Debt discharged in a Title 11 bankruptcy case, such as Chapter 7 or Chapter 13 bankruptcy, is another significant exclusion from taxable income. If debt is discharged through a court-approved bankruptcy plan, the amount forgiven is generally not considered taxable income for federal purposes.

Qualified Principal Residence Indebtedness

Debt incurred to acquire, construct, or substantially improve a taxpayer’s main home can also be excluded under specific conditions. This exclusion applies to debt discharged before January 1, 2026, or under a written agreement entered into before that date. The maximum amount that can be excluded is $750,000 ($375,000 if married filing separately).

Student Loan Discharges

Certain student loan discharges are also not considered taxable income. Forgiveness occurring between January 1, 2021, and December 31, 2025, is tax-free. This includes forgiveness under income-driven repayment plans and Public Service Loan Forgiveness (PSLF). Additionally, student loans canceled due to working for certain government or educational institutions, or due to death or total and permanent disability, may also be excluded. Other less common exclusions include qualified farm indebtedness and debt canceled as a gift.

Reporting Canceled Debt

When a debt of $600 or more is canceled, the lender is generally required to issue IRS Form 1099-C, “Cancellation of Debt,” to the borrower and the IRS. This form details the amount of debt canceled, the date of cancellation, and a code indicating the reason for the cancellation, like bankruptcy or foreclosure. Even if a Form 1099-C is not received, taxpayers are still responsible for reporting any taxable canceled debt.

Taxable canceled debt is typically reported on Schedule 1 (Form 1040). If an exclusion applies, such as due to insolvency or bankruptcy, taxpayers must file IRS Form 982, “Reduction of Tax Attributes Due to Discharge of Indebtedness,” with their tax return. Form 982 informs the IRS of the amount of canceled debt being excluded and the specific reason for the exclusion.

Review any received Form 1099-C for accuracy. If the information appears incorrect, contact the lender to request a correction. If the lender does not correct the form, report the correct amount on your tax return and attach an explanation.