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.
Is a cancellation of debt taxable? ›
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.
What happens if I don't report 1099c? ›
Discrepancies and Tax Audits
If you fail to report taxable debt income when you file your taxes, you may have to pay an additional negligence penalty. You also need to pay interest on your taxes, as well as other sanctions.
Does the IRS ever forgive debt? ›
The IRS offers a tax debt forgiveness program for taxpayers who meet their qualification requirements. To be eligible in 2024, you must claim extreme financial hardship and have filed all previous tax returns. The program is available only to those who qualify.
Can I file my own 1099c? ›
A lender files a 1099-C with the IRS – and they'll send you a copy of the form. 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.
Does a 1099-C affect your credit? ›
If the creditor doesn't send it before the tax deadline so you can file with the correct information, you'll need to file an amended return when you receive it. Though receiving a 1099-C doesn't hurt your credit, the canceled debt that led to it probably will.
Is cancellation of debt taxable after death? ›
The credit card companies report the forgiveness of deceased debt to the IRS by using a 1099-C – Cancellation of Debt form. Even if the credit card company fails to issue a 1099-C form, the cancellation of debt income is still reportable on the estate fiduciary income tax return.
Will the IRS catch a missing 1099-C? ›
The IRS employs various methods to detect discrepancies in tax reporting, including the absence of 1099 forms. While the IRS does not catch every missing 1099 immediately, their sophisticated systems and data-matching capabilities make it likely that discrepancies will be identified over time.
How do I avoid paying taxes on a 1099c? ›
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.
Can a creditor still collect after issuing a 1099-C? ›
In this event, the account is still delinquent, but the debt hasn't been forgiven, so the lender may still try to collect. The IRS amended the rule later that year, so creditors are no longer expected to file a 1099-C just because it's 36 months past due. But it is possible for it to still happen.
Generally, the IRS can include returns filed within the last three years in an audit. If we identify a substantial error, we may add additional years. We usually don't go back more than the last six years. The IRS tries to audit tax returns as soon as possible after they are filed.
Who qualifies for the IRS fresh start? ›
General Initiative Eligibility
You should be current on all federal tax filings and owe no more than $50,000 in back taxes, interest and penalties combined. If you're a small business owner, you could be eligible for relief under the Fresh Start Initiative if you owe no more than $25,000 in payroll taxes.
Can I negotiate with the IRS myself? ›
You can submit an offer on taxes owed individually and for your business. Here are the main reasons the IRS may agree to accept less than the full amount you owe: Doubt as to Collectability: This means you don't have enough income or assets to pay your balance due in full.
How much tax will I pay on 1099c? ›
That depends on your overall taxable income. Your income, including amounts listed on your 1099-Cs, gets taxed at the normal progressive rate, which ranges from 10% to 37%. How much tax you will owe depends on your tax bracket, filing status, credits, and deductions.
Do you have to pay taxes on cancelled debt? ›
The IRS does not consider borrowed money to be income. If the creditor cancels the loan, with some exceptions the amount of the forgiveness usually does become income. Then the forgiven debt is subject to taxation at your regular tax rate.
What happens if you file your taxes and then get a 1099c form? ›
Regardless of whether or not the 1099-C will increase your taxable income, you should be aware that the IRS receives a copy of this form as well, so you should fill out an amended tax return to reflect the changes. If you're claiming one of the allowed exclusions, you still need to tell the IRS why.
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.
How long does a cancellation of debt stay on your credit report? ›
Whether it's missed payments or charge-offs, they'll stay on your credit reports for seven years. Fortunately, settling debt does not mean your credit will be in the gutter during those seven years. Negative information has less impact on your credit score over time.
What happens if you cancel a debt management plan? ›
When you cancel, the provider will tell your creditors, so they might start charging you interest and late payment fees again, as well as expecting you to resume higher payments. You'll also have to deal with your creditors yourself again. Think about how you're going to cope with this.
