Taxes on Settled Debt: Is Forgiven Debt Taxable?

If you settle a debt for less than you owe, the part the creditor forgives usually isn’t free. In most cases the IRS treats canceled debt as income, which means it can raise your tax bill. This catches many people by surprise, and it can eat into the savings from a settlement. Here is how it generally works, and when it may not apply to you.

The short answer

Canceled debt is generally taxable income in the year the debt is canceled. A creditor that cancels $600 or more usually files Form 1099-C with the IRS and sends you a copy. Some situations let you exclude part or all of it, most often bankruptcy or insolvency. If you repay a debt in full, nothing is canceled, so this doesn’t come up.

Why forgiven debt counts as income

When you borrow, the money isn’t income because you owe it back. When a creditor cancels part of what you owe, you keep money you were supposed to repay. The tax rules treat that benefit as income.

Here is a simple example with made-up numbers. You owe $15,000 on a card, and the creditor accepts $5,000 as payment in full. The creditor cancels $10,000.

• You’d generally add $10,000 of canceled debt to your income for that year, unless an exclusion applies.
• If your federal tax bracket were an example 22%, the added tax would be about $2,200.
• Your actual tax depends on your income, your filing status and your state.

Form 1099-C

• A creditor generally files Form 1099-C when it cancels $600 or more of debt.
• You’d typically receive it in the following early part of the year.
• The form shows the amount of debt canceled and the date.
• Even if you don’t get a form, or the amount is under $600, canceled debt is generally still reportable. The form is a reporting requirement for the creditor, not what creates the tax.

If you think the form is wrong, contact the creditor and ask for a corrected one.

Exclusions that may apply

Not all canceled debt is taxable. The most common exclusions include:

• Bankruptcy. Debt discharged in a bankruptcy case is generally not counted as income.
• Insolvency. If your debts were greater than your assets right before the cancellation, you may exclude the canceled amount up to the amount you were insolvent.
• Other exclusions apply to specific kinds of debt.

You claim an exclusion by filing IRS Form 982 with your return. Claiming one can also mean reducing certain tax benefits, so it’s worth having a tax professional look at it.

An insolvency example

Another example with made-up numbers. Right before a settlement, you owe $60,000 in total debts, including a card balance where $10,000 will be forgiven, and your assets are worth $52,000.

• You were insolvent by $8,000 ($60,000 minus $52,000).
• You may be able to exclude up to $8,000 of the canceled debt.
• The remaining $2,000 would generally still be taxable. At an example 22% bracket, that’s about $440.

The exclusion can never be more than the amount by which you were insolvent, and you’d need to document your assets and debts.

Planning ahead

• Ask before you settle. Factor possible tax into the real cost of a settlement.
• Keep records. Save settlement agreements, payment records and any Form 1099-C.
• Set money aside. If you expect to owe tax, don’t spend the “savings.”
• Talk to a tax professional. Whether an exclusion applies depends on details.
• Compare other options. Paths where you repay in full, like a consolidation loan or a nonprofit debt management plan, don’t create canceled-debt income. See how the options compare.

For the bigger picture on settlement, including fees and credit effects, read how debt settlement works.

This article is for general information only and isn’t tax, legal or financial advice. Tax rules change and depend on your situation, so check with a tax professional or the IRS. Examples use made-up numbers. The sponsored option on this page is paid advertising. See our advertiser disclosure.