Key takeaways
- In general, debt that’s canceled or settled for less than you owe counts as taxable income.
- Creditors file Form 1099-C when they cancel $600 or more, but you may owe tax on smaller amounts too.
- Exceptions exist, including debts discharged in bankruptcy and canceled while you were insolvent.
- The IRS’s Publication 4681 has an insolvency worksheet.
- Talk to a tax professional before you file.
When you settle a credit card debt for less than you owe, it can feel like the end of the story. But there may be one more chapter, at tax time. The IRS generally treats forgiven debt as income. Here’s how that works and when exceptions apply. This is general information, not tax advice.
Why forgiven debt can be taxed
When you borrowed the money, it wasn’t income, because you were expected to pay it back. If part of that debt is forgiven, you no longer have to repay it, so the IRS treats the forgiven part as income. According to the IRS, if your debt is canceled, forgiven or discharged for less than the amount owed, the canceled amount is generally taxable.
A simple example
These numbers are only for illustration. You owe $8,000 on a credit card. The card company agrees to accept $5,000 to settle it.
| Amount | |
|---|---|
| Amount owed | $8,000 |
| Amount paid to settle | $5,000 |
| Canceled debt | $3,000 |
Unless an exception applies, that $3,000 may count as income on your tax return.
What Form 1099-C is
Form 1099-C, Cancellation of Debt, reports the amount canceled. According to the IRS’s Publication 4681, lenders such as financial institutions must file it and send you a copy when they cancel $600 or more. The IRS also says you must report canceled debt as income even if it’s less than $600 and you don’t get a form, unless an exception applies.
If you get a 1099-C:
- Check the amount and date. Mistakes happen. If it’s wrong, contact the creditor and ask for a corrected form.
- Don’t ignore it. The IRS gets a copy.
- Keep your settlement paperwork with your tax records.
Exceptions and exclusions
The IRS lists situations where canceled debt may not be taxable, including:
- Insolvency. If your total debts were more than the value of everything you owned right before the debt was canceled, you may exclude some or all of the canceled amount. Publication 4681 includes an insolvency worksheet.
- Bankruptcy. Debts discharged in a bankruptcy case generally aren’t taxable.
- Certain other types of debt, such as some qualified farm or real property business debt, and some types of student loan forgiveness, under specific rules.
If you use an exclusion, you generally report it on Form 982, and some of your tax benefits may be reduced. This is where a tax professional is worth it.
Insolvency, explained simply
Add up everything you owed right before the cancellation, including the canceled debt. Then add up the fair market value of everything you owned: bank accounts, car, retirement accounts, home equity and so on. If what you owed was more than what you owned, you were insolvent, by that difference.
You can exclude canceled debt up to the amount you were insolvent. Many people who settle debts are insolvent at the time, which is why this exception matters, but you must calculate it and keep records.
Plan for it before you settle
If you’re considering debt settlement:
- Ask how much debt is likely to be forgiven, and estimate the tax.
- Find out whether you might be insolvent.
- Set aside money for possible taxes if you can.
A debt management plan repays the full balance, so there’s no canceled debt to tax. Compare the options in debt settlement vs. debt consolidation.
Free tax help
If your income is below certain limits, the IRS’s Volunteer Income Tax Assistance (VITA) program offers free tax preparation. The Taxpayer Advocate Service also explains canceled debt in plain language.
The bottom line
Forgiven debt is usually taxable, but not always. Check any 1099-C you receive, learn whether insolvency or bankruptcy applies to you, and talk to a tax professional before you file.
Sources: IRS Topic 431: canceled debt · IRS Publication 4681 · Taxpayer Advocate Service: cancellation of debt