6 exceptions to paying tax on forgiven debt
Exclusions mean you may not have to count some canceled debt as income
If you had debt forgiven, wiped out or negotiated away last year, you may owe income taxes on the amount of debt erased.
However, there are a number of exceptions that allow you to exclude all or part of a forgiven debt, meaning big savings on your tax bill. Here are the six exceptions to paying taxes on canceled debt.
1099-C tax surprise
If a debt of $600 or more is forgiven or canceled, the IRS requires the creditor to issue a 1099-C tax form to the borrower to show the amount of debt not paid. The IRS then requires the borrower to report that amount on a tax return as income, and it's often an unpleasant surprise:
Exception 1: Debts canceled when you were insolvent
This is the most sweeping exception, because debt is generally only canceled when debtors are "insolvent" – IRS-speak for being broke. Take note, however, the exclusion applies only up to the amount by which you are insolvent.
Example: Trisha owed $30,000 in credit card debt, which she settled by paying $5,000. She received a Form 1099-C showing canceled debt income of $25,000 ($30,000 minus $5,000). She had no other debts. Her assets at the time were worth $2,000.
- Canceled debt: $25,000
- Total assets: $2,000
- Insolvency amount: $23,000
- Trisha reports $2,000 ($25,000 minus the $23,000 insolvency amount) as income on her tax return.
Exception 2: Debts discharged in bankruptcy
If you filed for bankruptcy protection, do not report the canceled debt as income.
Example: John was successfully sued for $500,000. He subsequently filed for bankruptcy and had the $500,000 debt, among other debts, canceled. John does not pay tax on the canceled debt.
Exception 3: Student loans forgiven after you worked a period of time
If your student loans contain a loan forgiveness provision based on service in your field of work, do not include the canceled debt as income. (Also, certain federal student loans that were discharged by the U.S. Education Department's "Defense to Repayment" or "Closed School" discharge process are exempt. These loan discharge programs affect students at Corinthian Colleges and American Career Institutes Inc.)
Example: After Natalie finished her medical residency, she worked in an underserved area as a physician, as she agreed to under a loan forgiveness program. She does not, therefore, have to pay tax on the canceled student loans.
- The U.S. Education Department is considering restricting the loan forgiveness programs, and students have reported difficulty qualifying for breaks on loans under the Public Service Loan Forgiveness program.
- However, loans that are forgiven under the programs are exempt from taxes by the IRS.
- New for 2017 tax year: As part of the federal tax overhaul enacted at the end of 2017, student loan debt that was forgiven because of death or disability is no longer subject to taxes.
New for 2017: Break on mortgage debt due to foreclosure has expired.
There used to be an additional exception to paying taxes on canceled debt, but it went away at the end of 2016 – although perhaps not permanently.
Taxpayers preparing their 2017 taxes are awaiting action in Congress to extend the Mortgage Forgiveness Debt Relief Act, a recession-era law that, after several renewals, expired at the end of 2016. The measure exempts from taxes home mortgage debt that was erased through a foreclosure or short sale. Enacted in response to the housing crisis, the measure has been extended previously.
In early 2018, as the tax season began, tax advisers recommended keeping a close watch on the issue if you had mortgage debt forgiven in 2017. Lawmakers may turn their attention to renewing the exclusion in February when the tax season heats up, tax experts said.
However, some are skeptical that lawmakers will renew the break. If you file a return and Congress later extends the debt relief act for 2017, you can file an amended return to take advantage of the exclusion.
Example: Joe and Emily lost their home when their adjustable rate mortgage reset at a higher rate, Joe lost his job, and the value of their home dropped by one-third.
- Joe and Emily owed $380,000 on their home, but after expenses, the bank only realized $300,000 from the sale.
- The bank reports $80,000 as canceled debt, which may be considered taxable income if the Mortgage Forgiveness Debt Relief Act is not extended for 2017.
- However, Joe and Emily might also qualify for a break on the tax if they are insolvent at the time of the foreclosure – see "Debts canceled when you were insolvent," below.
- For more details, see the U.S. Taxpayer Advocate Service's publication, "Cancellation of debt."
Exception 4: Forgiven interest that would have been deductible (such as interest on business debt)
You do not have to pay tax on the portion of the debt due to interest, if you could have deducted the interest if you had paid it.
On the other hand, if you could not have deducted it – for example, if it was interest on a personal credit card – you must pay taxes on all the forgiven debt, including the interest.
Example 1: You receive a Form 1099-C for forgiven debt on your business credit card, which you used only for your sole proprietorship business.
- The total canceled debt in box 2 on the form is $5,000 and the interest portion in box 3 is $2,000.
- Unless you qualify for any of the other exceptions, report the debt not including interest, or $3,000 ($5,000 minus $2,000), as income on the Schedule C for your business.
Example 2: The facts are the same as in the previous example, except it's your personal department store card.
- The interest is not deductible when paid; therefore it does not qualify for the exception.
- Unless you qualify for any of the other exceptions, report $5,000 on Form 1040, line 21 (for 2010).
Exception 5: Cancellation of debt as a gift
If the cancellation of debt is a gift, it's not income.
- Generally, the IRS will believe you if you say it is a gift and it's between parties such as family members or friends.
- The IRS takes a dim view of taxpayers claiming that canceled debt from banks, employers or anyone else with whom you have a strictly working relationship are "gifts."
- Note: If more than $13,000 of debt is canceled in one year, the gift giver has to file a gift tax return (although they almost certainly will not owe a tax). That should not affect you as the recipient.
Example: Roxy borrowed $6,000 from her dad while she was unemployed. She wrote up a promissory note for the debt. Now Dad says she doesn't have to repay him after all. Roxy does not have to report the forgiven $6,000 debt as income. (She should, however, make sure the promissory note is marked as "paid.")
Exception 6: Business, farm exclusions
In addition, you may not have to pay tax on canceled debt if it was in connection with your farm, or if the debts were attached to business real estate and were forgiven when you owed more than the property was worth.
If you received a 1099-C form and you qualify for one of these exceptions, you still have to tell the IRS that you don't have to include the forgiven debt as income and why. File Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your income tax form, and consider your old debt that much further behind you. For help with the form, review IRS Publication 4681.
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