What to Do if You Get a Notice of Debt Forgiveness
Forgiven debt can be considered income by the IRS. Learn the principles for determining taxability and the correct procedures for reporting it on your return.
Receiving a notice that a lender has forgiven a portion of your debt is known as a cancellation of debt. This occurs when a creditor discharges you from the obligation to repay what you owe. While this provides financial relief, the forgiven amount is often considered income by the Internal Revenue Service (IRS), creating a potential tax liability. You must determine if the forgiven amount must be reported as income or if you qualify for an exclusion that relieves you of this obligation.
Understanding Form 1099-C Cancellation of Debt
The official notice of debt forgiveness is IRS Form 1099-C, Cancellation of Debt. Federal regulations require entities like banks, credit unions, and government agencies to issue this form when they cancel $600 or more of a debt. They must send a copy to both you and the IRS by January 31 of the year following the debt cancellation. A creditor issues Form 1099-C after an “identifiable event” signals that the debt will not be collected, such as a settlement or a foreclosure.
The form contains several pieces of information. Box 2, “Amount of debt discharged,” shows the total amount of principal and interest forgiven, which is the figure that may be considered income. Box 6 provides a one-letter code indicating the “Identifiable event,” for example, code “G” signifies a “Decision or a policy to discontinue collection.”
General Taxability of Canceled Debt
The foundational rule under U.S. tax law is that canceled debt is considered part of your gross income. When a lender forgives a debt, you are no longer required to pay back money you previously received, resulting in an increase to your net worth. The IRS views this as an accession to wealth, making it subject to income tax.
Therefore, the amount shown in Box 2 of Form 1099-C should be reported on your tax return as “Other Income.” This rule applies to various types of debt, including credit card balances, personal loans, and medical bills. Even if you do not receive a Form 1099-C, for instance if the canceled amount is less than $600, you are still legally required to report the forgiven debt as income.
Common Exclusions from Gross Income
While canceled debt is taxable, several exclusions may allow you to avoid including it in your income. Claiming an exclusion requires filing an additional form with your tax return to explain why the forgiven debt is not taxable. The most common exclusions are detailed in IRS Publication 4681.
Some of the most common exclusions include:
- Debts discharged in a Title 11 bankruptcy case, which includes Chapter 7, 11, or 13 bankruptcies. If a debt is discharged in bankruptcy, this exclusion takes precedence over others.
- Insolvency, which applies if your total liabilities exceed the fair market value of your total assets immediately before the debt cancellation. The amount you can exclude is limited to the amount by which you are insolvent. For example, if you have $50,000 in assets and $80,000 in liabilities, you are insolvent by $30,000 and can exclude up to that amount of canceled debt.
- Qualified principal residence indebtedness, which allows you to exclude canceled mortgage debt on your main home. This applies to debt used to buy, build, or substantially improve your principal residence and is limited to $750,000 ($375,000 for married individuals filing separately) for discharges before January 1, 2026.
- Qualified farm indebtedness and qualified real property business indebtedness, which have their own specific requirements.
Required Tax Reporting and Filings
How you report canceled debt depends on whether it is taxable or excludable. If the debt is taxable, you must report the amount from Box 2 of Form 1099-C on Schedule 1 of Form 1040, on the line for “Other Income.”
If you qualify for an exclusion, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. On this form, you check the box that corresponds to your situation, such as for a discharge in bankruptcy or the insolvency exclusion. You will also enter the amount of the discharged debt you are excluding from income.
Using an exclusion may require you to reduce certain “tax attributes.” This means you might have to decrease the basis of property, net operating losses, or tax credit carryovers, which could affect your tax liability in future years. For instance, excluding qualified principal residence indebtedness requires you to reduce your basis in that home, which could lead to a higher taxable gain when you sell it.
Addressing an Incorrect Form 1099-C
If you receive a Form 1099-C that you believe is incorrect, contact the creditor who issued it. Explain the discrepancy, such as an inaccurate amount or a debt that was not canceled, and request a corrected Form 1099-C. Keep detailed records of your communications with the creditor. If the creditor agrees, they can issue a corrected form with the “Corrected” box checked at the top.
If the creditor refuses to issue a correction, you must still address the issue on your tax return. Report the amount from the incorrect 1099-C and then subtract the disputed amount on the same line. You must attach a statement that explains the situation in detail to inform the IRS why your reported income differs from the amount on the form.