No matter how hard you try to keep your debt under control, sometimes it piles up. Depending on your situation, you may be able to cancel some of your debt. That would probably lift a huge weight off your shoulders. But even if your creditor lets you ditch some of your debt, there might be a catch. In some cases, canceled debt can increase your tax bill.
A financial advisor can help you answer questions about debt cancelation and optimize your financial plan to manage debt.
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How Is Canceled Debt Taxable?
If your creditor cancels some of your debt, the IRS may count it as income. Why? Let’s look at an example.
Let’s say you have $3,500 in credit card debt but can only afford to pay back $3,000. If your creditor cancels the rest of your debt, you won’t have to pay back the $500 you owe. So when you think about it, you’re essentially $500 richer. That’s why canceled debt is often considered an income gain.
Paying more in taxes because you can’t pay off your debt may seem unfair. But without some consequences for delinquent borrowers, it would be too easy to borrow money and not pay it back.
What Kind of Canceled Debt IsTaxable?
In most cases, canceled debt is taxable. Your debt may be canceled if your creditor stops trying to collect the money you owe. If it’sdischarged through a bankruptcy, it may be considered taxable income.
A modification of your mortgage loan may be considered a taxable cancellation of debt as well. If you face foreclosure or your property is repossessed or abandoned, the IRS may consider the cancellation of your mortgage debt to be the equivalent of a home sale. If that happens, you may end up with a taxable capital gain or loss.
Forgiven debt can be taxable, too. Even if you were paying your student loans through an income-driven repayment plan, your forgiven debt may be subject to taxation. One exception to that rule is student debt forgiven through the Public Service Loan Forgiveness Program or a similar initiative.
Cancellation of Debt Income Exceptions
Luckily, there are other exceptions to the IRS guidelines regarding canceled, forgiven and discharged debt. If you’re buying a property and the seller offers a purchase price reduction, the amount you don’t have to payisn’t considered cancellation of debt income (and therefore doesn’t need to be included on your tax return). The same rule applies if you’re relieved of your obligation to pay back gifts and inheritances or your accountant agrees to cancel debt that would have otherwise been a deductible expense.
If your principal mortgage balance is lowered because the government makes payments on your behalf, those incentive payments aren’t considered cancellation of debt income. This may happen if you’re part of theHome Affordable Modification Program.
Cancellation of Debt Income Exclusions
Cancellation of debt income isn’t subject to taxation if it’s excluded from your gross income. Any debt that’s discharged in a Title 11 bankruptcy isn’t included in your gross income. That exclusion applies to debt canceled during insolvency, too. Insolvency occurs when your debt is forgiven because you have more liabilities than assets.
You may also qualify for anexclusion following the cancellation of your farm debt or real property business debt. If you qualify for mortgage debt relief, your forgiven debt can be excluded from taxable income as well. Just keep in mind that you may need to file Form 982 along with your tax return.
How Do I Report Canceled Debt to the IRS?
After your creditor cancels your debt, you may have to report it to the IRS. You would include it with your tax return following the year the cancellation occurred. When at least $600 in debt is canceled, your collector will send you IRS Form 1099-C. The form will state the amount of debt that the collector canceled. That is the amount you must report to the IRS on your tax return. If you think the information is incorrect, be sure to contact your creditor.
When you receive Form 1099-C, it’s best not to ignore it. Your debt collector will send a copy of the form to the IRS as well. So they’ll expect your tax return to include the canceled debt amount. Failure to report the canceled debt could result in a tax bill or an audit.
Even if you don’t receive Form 1099-C, you’ll still need to report your canceled debt to the IRS. If you’ve received a 1099-C form and your creditor is still trying to collect your unpaid debt, it may not have been canceled.
Bottom Line
Debt cancellation may sound great. But your tax liability often increases when your debt’s canceled. If you’re unsure whether your canceled debt qualifies for an exception or exclusion from taxation, it’s best to see a tax professional. That way, you can avoid mistakes that may result in a tax penalty.
Tax Planning Tips
- If you need tax planning help, don’t hesitate to enlist the help of a financial advisor or another type of financial professional.Finding afinancialadvisordoesn’thaveto behard. SmartAsset’s free tool matches you with up to three vettedfinancialadvisorswho serve your area, and you can interview youradvisormatches at no cost to decide which one is right for you. If you’re ready to find anadvisorwho can help you achieve yourfinancialgoals, get started now.
- It you’re expecting atax refund, having a plan can increase the chances that you’ll put it to good use. Here are five smart ways to invest your tax refund in 2023.
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FAQs
In most cases, canceled debt is taxable. Your debt may be canceled if your creditor stops trying to collect the money you owe. If it's discharged through a bankruptcy, it may be considered taxable income. A modification of your mortgage loan may be considered a taxable cancellation of debt as well.
Do I have to pay taxes on cancelled debt? ›
In general, if your debt is canceled, forgiven, or discharged for less than the amount owed, the amount of the canceled debt is taxable. If taxable, you must report the canceled debt on your tax return for the year in which the cancellation occurred.
Is cancellation of debt taxable to an estate? ›
If the debt is forgiven, it becomes ordinary income reportable on the estate's fiduciary income return regardless if a Form 1099-C was issued by the creditor.
Do I have to pay taxes on loan forgiveness? ›
According to the IRS, student loan amounts forgiven under PSLF are not considered income for tax purposes. Learn more about the PSLF process. You won't be taxed by the federal government, but your state may tax you. Any debt forgiven as a result of PSLF won't create a federal tax liability for you.
When can a taxpayer exclude all income from their cancelled debt? ›
Discharged debt is excluded from gross income if the discharge occurs when the taxpayer is insolvent. For purposes of the exclusion, insolvency is defined as the amount in which the taxpayer's liabilities exceed the taxpayer's assets. The amount excluded by an insolvent taxpayer is limited to the amount of insolvency.
How much tax will I pay on cancelled debt? ›
There are no direct taxes on a debt settlement, but if you save $600 or more, you will have to report the savings as income. To continue with the above example, the $2,000 you saved on that credit card debt is taxable income. You report it on your tax return and pay taxes based on your situation.
How badly does a 1099-C affect my taxes? ›
While you don't have to file the 1099-C, you should use it to prepare and file your income tax return. In some cases, your forgiven debt is taxable – and in some it's not. When it is taxable nonbusiness debt, you'll use the copy of the 1099-C to use to report it on Schedule 1 of Form 1040 as other income.
Do you have to file a 1099-C cancellation of debt? ›
You will receive a 1099-C Cancellation of Debt form if a lender forgives more than $600 of taxable debt on your behalf. You must include the amount of canceled debt on your federal tax return as a part of your taxable income. There are instances that warrant the exclusion of forgiven debt from your return.
What does a 1099-C cancellation of debt mean? ›
Form 1099-C is used to declare amounts of $600 or more that are forgiven or canceled by a lender or creditor, including the abandonment of secured property or foreclosure. The amounts reported on the form may include principal, interest, fines, late fees, penalties, and administrative costs.
Where do I put cancellation of debt on my taxes? ›
Lenders or creditors are required to issue Form 1099-C, Cancellation of Debt, if they cancel a debt owed to them of $600 or more. Generally, an individual taxpayer must include all canceled amounts (even if less than $600) on the "Other Income" line of Form 1040.
Cancellation of debt is the forgiveness of debt obligations by a creditor. Debt relief can be achieved through direct negotiations, debt relief programs, or bankruptcy. Canceled debt is generally considered taxable income that must be reported, but there are many exceptions.
How do I not pay taxes on forgiven debt? ›
If you can demonstrate to the IRS that you were insolvent at the time the debt was cancelled, you can similarly avoid taxes on that debt. Certain other types of debt, including qualified farm indebtedness and qualified real property business indebtedness, can also avoid taxation in the event of cancellation.
What is the IRS form for cancellation of debt? ›
File Form 1099-C for each debtor for whom you canceled $600 or more of a debt owed to you if: You are an applicable financial entity. An identifiable event has occurred.
What happens if I don't receive a 1099-C? ›
Even if you didn't receive a Form 1099-C, you must report canceled debt as gross income on your tax return unless one of the exceptions or exclusions described later applies. Amount of canceled debt. The amount in box 2 of Form 1099-C may represent some or all of the debt that has been canceled.
How do I record cancellation of debt on 1040? ›
Generally, data from a Form 1099-C, Cancelled debt (box 2) is reported on Form 1040, line 21 for 2017 and prior. But for 2018, 2019 and 2020, it is reported on 1040 Schedule 1 Line 8, for 2021 on 1040 Schedule 1 line 8z, using Wkt 7.
Is there a statute of limitations on cancelled debt? ›
There aren't statutes of limitations on the cancellation of debt, though the IRS does have rules about when these forms should be filed. The creditor must file a 1099-C the year following the calendar year when a qualifying event occurs.
How to avoid paying taxes on cancelled debt? ›
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.
What happens if I don't report cancellation of debt? ›
If you don't report the taxable amount of the canceled debt, the IRS may send you a notice proposing to assess additional tax and may audit your tax return. In addition, the IRS may assess additional tax, penalties and interest. 3.
What happens when you file a cancellation of debt? ›
Cancellation of debt is the forgiveness of debt obligations by a creditor. Debt relief can be achieved through direct negotiations, debt relief programs, or bankruptcy. Canceled debt is generally considered taxable income that must be reported, but there are many exceptions.
Where does cancellation of debt go on tax return? ›
Lenders or creditors are required to issue Form 1099-C, Cancellation of Debt, if they cancel a debt owed to them of $600 or more. Generally, an individual taxpayer must include all canceled amounts (even if less than $600) on the "Other Income" line of Form 1040.
