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If you've succeeded in getting a debt discharged or forgiven, you may need to report the canceled amount as income on your tax return. Know what to expect, so you don't end up with a huge tax bill.
What Is Cancellation of Debt?
Debt cancellation happens when a lender forgives or discharges some or all of a debt that you owe. The process typically doesn't affect your credit score—unless it happens in bankruptcy—but it could end up costing you. Debt cancellation typically happens in accordance with a debt forgiveness program.
For example, the U.S. Department of Education offers income-driven repayment plans to federal student loan borrowers. If you get on one of these plans, your repayment term will last 20 or 25 years, after which any remaining debt is forgiven.
With debt cancellation, you're no longer on the hook for the canceled amount, and you don't have to worry about the lender coming after you in the future.
How Does Canceled Debt Affect Taxes?
The IRS considers most forms of forgiven, canceled or settled debt as income for tax purposes. If the amount of your canceled debt is more than $600 and it's considered taxable, the lender is required to send you a 1099-C form, which includes the cancelled amount that you'll need to report.
If your forgiven debt is less than $600, you might not get a 1099-C, but you'll still need to report it on your tax return.
Depending on how much debt has been discharged and your current tax situation, a canceled debt could result in a massive tax bill. So if you've recently taken advantage of a debt forgiveness program, you'll want to find out whether it's taxable and how to prepare, so you don't get blindsided at tax time.
Is All Canceled or Forgiven Debt Taxable?
While most canceled debts are considered taxable, there are a few exceptions to the rule. If your situation falls under one of these categories, you might still need to report the debt, but it won't be counted toward your gross income.
- Bankruptcy: If your debt was discharged in bankruptcy, it's not considered taxable income. The idea is that you're already hurting financially, and requiring you to pay taxes could make things even more difficult.
- Insolvency: If you're financially broke at the time of the cancellation—your liabilities exceed your assets—you may be able to exclude some or all of your canceled debt from your income on your tax return. The IRS determines how much you can exclude based on the extent of your financial insolvency.
- Gifts: If you borrowed money from your parents or a friend and they decided not to collect the full amount from you, that's considered a gift for tax purposes.
- Tax-Deductible Interest: If you've had a business or mortgage loan canceled, where the interest was considered tax-deductible, you won't need to report the interest portion of the forgiven amount as income. You will, however, still need to report the canceled principal amount.
- Certain Student Loans: If you've had your student loans forgiven in return for service in a specific field or career for a set period of time, the amount forgiven is not considered taxable income. The same goes if your student loans have been discharged due to death or permanent disability.
- Farm or Real Estate Debt: If your debt was attached to a farm or real estate business and you meet other eligibility requirements from the IRS, you may qualify for a special exclusion.
The Difference Between Canceled Debt and Debt Settlement
Having a debt canceled or forgiven is a little different than settling a debt for less than what you owe. While debt forgiveness typically happens as part of a specific program, debt settlement often occurs when you're struggling to pay what you owe and are behind on payments.
Also, debt settlement is typically only available for unsecured debts, including credit cards and personal loans. In a debt settlement situation, your credit might already be in bad shape, and settling can damage your credit even more.
On the flip side, debt cancellation typically doesn't have a negative impact on your credit score. In either case, though, you may need to report the debt as income on your tax return.
If It's Taxable, Be Prepared
If you've taken advantage of a debt forgiveness program, the sooner you find out about the tax implications, the better. Speak with a tax professional to find out whether you qualify for an exception. If you do, you don't need to do anything else.
If you don't, however, you may need to start preparing for the tax bill. A tax professional can help you run the numbers based on how much you currently have withheld from your paychecks and which deductions and credits you qualify for.
If you end up owing money, start working on a savings plan now to ensure you can afford to pay it. While the IRS offers installment plans for people who can't afford to pay by the due date, they charge interest and a penalty until you pay in full.