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6 exceptions to paying tax on forgiven debt

You may not need to report canceled debt if it was discharged in bankruptcy or forgiven while you were insolvent


Before you write a check to the IRS for forgiven debt, see if you qualify for one of these exceptions to paying tax on that debt you didn’t have to pay

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If you had debt forgiven, wiped out or negotiated away last year, you may owe income taxes on the amount of debt erased.

Logan Allec, a certified public accountant based in Santa Clarita, California, said that debt relief, including forgiven credit card debt, is considered taxable income in the majority of cases.

“We in the tax world even have an acronym for it: COD income,” Allec said. “It stands for ‘cancellation of debt.’”

If you did have debt forgiven last year, you will receive a 1099-C form from your creditor that lists the debt that was wiped out. This amount is what you’ll have to pay taxes on.

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.

See related: Best credit cards to pay your taxes

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.

  • This is thanks to the Public Service Loan Forgiveness Program. This program has seen its struggles, though, with a review from the Government Accountability Office in 2019 finding that the U.S. Department of Education turned down 99% of people who applied for loan forgiveness under an expansion of the program known as the Temporary Expanded Public Service Loan Forgiveness program.
  • Many of these rejections were because applicants didn’t first apply for and hadn’t been denied forgiveness through the main Public Service Loan Forgiveness Program. The U.S. Department of Education has since consolidated both forgiveness programs into a single application form, simplifying the process.
  • However, loans that are forgiven under the programs are exempt from taxes by the IRS.
  • If you have suffered a total and permanent disability and had student loan debt forgiven because of this, you might not have to pay taxes. It depends on when your debt was discharged. According to IRS rules, if you received a total and permanent disability discharge of a student loan before Jan. 1, 2018, the amount of debt forgiven will be considered income and you’ll have to pay taxes on it. If your student loan debt was forgiven after Jan. 1, 2018, it won’t be considered income and you won’t have to pay taxes on it.
  • The discrepancy is thanks to the Tax Cuts and Jobs Act that President Donald Trump signed into law in 2017. This holds true for both private and federal student loans.

New for 2020 tax year: Mortgage debt

  • Thanks to the federal government’s Consolidated Appropriations Act, which was signed into law on Dec. 27, 2020, taxpayers who’ve had mortgage debt forgiven might not have to pay taxes on it when filing their 2020 income taxes this year.
  • That’s because the act extends the Qualified Principal Residence Indebtedness exclusion through the 2025 tax year. But it also reduced the amount of forgiven mortgage debt that won’t be considered income. Under the change, taxpayers who’ve had up to $750,000 in debt forgiven as part of a foreclosure, short sale, deed in lieu of foreclosure or loan modification might not have to pay taxes on it.

According to the new law, this exclusion will apply to mortgage debt forgiven before Jan. 1, 2021.

Say taxpayers who owed $205,000 on their mortgages lost their home to foreclosure and their lender sold it for $200,000. This means their lender forgave these former homeowners $5,000 in debt. Because of the new appropriations act, which basically reinstates the same type of relief found in the Mortgage Forgiveness Debt Relief Act of 2007, these taxpayers will not have to pay taxes on that $5,000.


  • Joe and Emily owed $380,000 on their home, but the bank only realized $300,000 from the sale after expenses.
  • The bank reports $80,000 as canceled debt, which would be considered taxable income if not for the new appropriations act.
  • Joe and Emily might qualify for a break on the tax, too, if they were 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 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 someone gives you gifts worth more than $15,000 in a year, that person will have to file Form 709, informally known as the gift tax return. Even if donors give more than $15,000 in a year, it’s unlikely that they will have to pay a tax on this excess money. 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.”)

See related:Paying taxes with a credit card is an expensive option

Exception 6: Business, farm exclusions

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.

See Cancellation of Debt in IRS Publication 225, Farmer’s Tax Guide or Business Income in IRS Publication 334, Tax Guide for Small Business for more information.

What to do if you still get a 1099-C

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.

Leslie Tayne, a financial debt resolution attorney and owner of Tayne Law Group in New York City, said that if your forgiven debt doesn’t fall under one of these exceptions, you are responsible for paying taxes on it.

This holds true even if the information on the 1099-C form you received is incorrect, Tayne said.

“Receiving an incorrect 1099-C form does not exempt you from having to pay taxes on your canceled debt,” Tayne said. “If you received a form with incorrect information or you received a form but the creditor is still trying to collect your debt, contact the creditor directly. You will want to get the situation worked out before filing your taxes.”

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