Debt settlement is a process for negotiating with your creditors to settle your outstanding debts for less than you owe. While that can save you money, it also has tax implications you should know about before you proceed. Certain types of debt are not subject to taxation, however, such as debt that is canceled due to a gift, bequest, or inheritance, certain types of student loan forgiveness, and debt discharged through Chapter 7, 11, and 13 bankruptcy.
Key Takeaways
- Debt settlement can erase some of your debts but also leave you with a substantial tax bill.
- Most canceled debt is considered income to you and taxed at the same rate as your other income.
- However, certain types of canceled debts are not taxable under IRS rules - including debt forgiven as gifts, bequests, or inheritance, student loan debt under certain circ*mstances, and debt discharged through Chapter 7, 11, and 13 bankruptcy.
Understanding Taxable Canceled Debt
When a creditor allows you to pay off an account for less than you owe, the amount you didn't have to pay is referred to as canceled debt. For example, if you owe $10,000 and the creditor agrees to accept $6,000 as payment in full, you have $4,000 in canceled debt. In many cases, that canceled debt is considered taxable income.
If the amount of the canceled debt is $600 or more, the creditor should send you a Form 1099-C, Cancellation of Debt before you file your taxes for the year. The information on this form is also reported to the Internal Revenue Service. The law requires that you report all taxable canceled debt as income on your tax return, even if the amount is less than $600 and you didn't receive a Form 1099-C.
Canceled debt is taxed at same rate as your ordinary income, which can be anywhere from 10% to 37% depending on your total taxable income. For example, if your tax rate is 22% and your canceled debt is $5,000, you would owe $1,100 ($5,000 x 0.22) on the canceled debt.
Even though creditors are not required to report canceled debt of less than $600 to the IRS it is the responsibility of the taxpayer to report any forgiven debt as regular income on their federal tax return, unless the forgiven debt is not subject to taxation.
Exemptions and Exclusions for Debt Settlement
Not all canceled debt is taxable, however, because the law allows for certain exceptions and exclusions. In effect, exceptions are canceled debts that aren't considered canceled for tax purposes, while exclusions are considered canceled debts but not subject to taxation. Either way you don't have to pay tax on them.
Exceptions to Taxable Canceled Debt
- Debt that is canceled as a gift, bequest, or inheritance
- Student loan debt canceled as the result of employment for a required length of time in a certain profession or for a particular type of employer
- Certain student loans discharged between Dec. 31, 2020, and Jan. 1, 2026
- Student loans forgiven through certain student loan repayment assistance programs
- Canceled debt that would normally be deductible if you had paid it as a cash basis taxpayer
- Any qualified purchase price reduction provided by the seller of a property
Exclusions of Canceled Debt From Gross Income
- All debt canceled under Title 11 bankruptcy. (Title 11 includes Chapter 7, Chapter 11, and Chapter 13 bankruptcies, among other types.)
- Debt canceled due to insolvency
- Qualified farm indebtedness
- Qualified real property business indebtedness
- Qualified principal residence indebtedness discharged before Jan. 1, 2026
Strategies to Minimize Tax Liability on Debt Settlement
As noted above, proving yourself to be insolvent or filing for bankruptcy are two strategies that can minimize your tax liability from a debt settlement.
Insolvency
Insolvency is when your debt exceeds your assets, leaving you with no way to pay your debts. However, there is a limit to this exclusion: Only the amount by which you are insolvent is excluded.
For example, say you have $80,000 in assets and $90,000 in debts. Because you owe $10,000 more than you have in assets, you are insolvent to the extent of $10,000.
If you arrange for debt settlement on your credit card debt and $15,000 is forgiven, only $10,000 is excluded because that's the extent to which you are insolvent. The balance of $5,000 is considered taxable income.
Bankruptcy
Debt discharged through Title 11 bankruptcy is not taxable. Title 11 shouldn't be confused with the well-known form of bankruptcy known as Chapter 11. The latter is one of several types of bankruptcy that are included in Title 11. Most individuals file either Chapter 7 or Chapter 13 bankruptcy, while Chapter 11 is primarily for companies.
Reporting Debt Settlement on Tax Returns
All taxable canceled debt must be reported on your annual federal income tax return. To do so, follow these steps.
- Add up the amounts on any Form 1099-Cs you received from your creditors. Note that it is your responsibility to keep track of and report all of your taxable canceled debt even if you didn't receive a 1099-C.
- Enter the total amount of taxable canceled debt on line 8c of the Schedule 1: Adjustments to Income and Additional Income form.
- Enter your total Schedule 1 income on line 8 of Form 1040 on your federal tax return.
Seeking Professional Tax Advice
Determining what is and is not taxable canceled debt can be confusing. So it's often a smart idea to seek professional tax advice. A good starting point would be to speak with a certified credit counselor. You can find one through such organizations as the Financial Counseling Association of America and the National Foundation for Credit Counseling.
Talking with a knowledgeable accountant or tax attorney could also be helpful, although more expensive.
Can Debt Settlement Result in Taxable Income?
Yes, you may have to pay taxes on any canceled debt that is considered income.
How Does Debt Settlement Affect Your Credit?
Debt settlement can have a negative impact your credit and typically stays on your credit reports for up to seven years.
What Is Form 982?
IRS Form 982 is used to determine if any canceled debt can be excluded from your gross income and, therefore, not taxed.
What Is Form 1099-C for Cancellation of Debt?
Form 1099-C is the IRS form that creditors use to report the amount of canceled debt and the date it was canceled.Both you and the IRS should receive copies if the amount is $600 or more.
When Should I Seek Professional Tax Advice for Debt Settlement?
If you have questions about what canceled debt is taxable following a debt settlement, it's highly recommended that you seek advice from a knowledgeable accountant or other tax professional. Failing to report taxable income or pay the appropriate tax on it can result in penalties and potential legal problems.
The Bottom Line
Debt settlement can provide a lifeline for individuals looking for a way out of crushing debt. However, they may face a significant tax bill if their canceled debt is taxable. Anyone in that situation who can't come up with the money to pay the tax should contact the IRS and ask about an installment payment plan or other options. However, some types of debt are not taxable so it pays to know the difference.
