If you have a debt discharged through some form of settlement, that can often feel like a huge relief. However, there may be more to consider than just the face value of the forgiven debt.
The IRS expects you to pay tax on the forgiven debt. That’s because the IRS considers most forgiven debt to be the same as income to you.
What Are Debt Settlement and Forgiven Debt?
Debt is a borrowed sum of money or a charge for a good or service that is expected to be repaid in the future. Debts may be either unsecured or secured.
Unsecured debts are a general liability to you, the borrower, and are not backed by an asset. Credit card debt is a type of unsecured debt. Debts may also be secured by a property. For example, a mortgage is a specific type of debt that is secured by your home. A car loan is another common example of secured debt.
Either type of debt may be cancelled through a debt relief settlement. The type of debt you have and the amount that is forgiven will impact your tax liability.
If the debt is forgiven or discharged for less than the amount you owe, the IRS considers the cancellation value to be the difference between your debt obligation and the price you paid to have the debt erased.
When Is Forgiven Debt Taxable?
In most cases, if a debt is cancelled or discharged by agreement for less than you owe, you will have to pay taxes on the cancelled amount. For instance, say you have a $10,000 debt that your lender agrees to discharge in exchange for $4,000. You had $6,000 of cancelled debt, and that’s the amount you owe taxes on.
The tax on cancelled debt is due in the year the debt is cancelled. The taxable portion of your cancelled debt needs to be reported on your tax return for that year just like any other income.
There are, however, some notable exceptions that we will discuss in a moment.
How Is Forgiven Debt Taxed? At the Same Rate as Income?
Since the IRS views most forgiven debt as income, it is usually taxed at the same rate as your income. Remember that federal income tax rates are progressive, so higher levels of income are taxed at higher rates and there is no single income tax rate. The rate at which your forgiven debt is taxed depends on how much other taxable income you have.
Figuring out how much you owe
When figuring the taxable portion of your forgiven debt, pay special attention to the details when that debt is secured by property. If the creditor takes that property as part of the debt settlement, the transaction is treated as though that creditor bought the property from you.
In that case, whether the cancelled debt was a recourse or nonrecourse loan will affect how you are taxed. A recourse debt is a secured debt that the borrower is personally liable for. That means the creditor can still collect on the debt even after the collateral is seized or sold. Nonrecourse debt does not allow the creditor to collect any additional debt beyond the collateral.
The income you realize from the cancellation of a recourse debt is the difference between the amount of debt that was forgiven and the fair market value of the collateral property.
Since this transaction is treated as a sale you’ll also need to report a gain or loss on the difference between the fair market value and your cost basis in the property. Cancellation of nonrecourse debt does not result in income, only gains or losses, based on the difference between your basis (cost) and the amount of debt forgiven.
Example of forgiven debt tax amount
- Suppose you borrowed $45,000 to buy a piece of property worth $50,000. You also made a $5,000 down payment.
- After making several payments, you still owe $40,000 to your lender.
- Now assume that you can no longer make the payments and the creditor repossesses the property and writes off your debt, but the fair market value of your property has fallen to $35,000.
- If you have a recourse debt then you need to report the $5,000 difference between your forgiven debt ($35,000) and the fair market value ($40,000) of the property as income.
- Since you effectively “sold” the property for $35,000 you also have a loss of $15,000 since you paid $50,000.
- If the debt is a nonrecourse loan then you have a loss of $10,000, the difference between the forgiven debt of $40,000 and your cost of $50,000.
What Are the Exceptions?
There are a few exceptions that apply to treating cancelled debt as income. The IRS specifically says that cancellations in the following scenarios are not treated as cancellation of debt income:
- Amounts cancelled as gifts, bequests, devises, or inheritances.
- Certain qualified student loans cancelled under the loan provisions that the loans would be cancelled if you work for a certain period of time in certain professions for a broad class of employers.
- Certain other education loan repayment or loan forgiveness programs to help provide health services in certain areas.
- Amounts of cancelled debt that would be deductible if you, as a cash basis taxpayer, paid it.
- A qualified purchase price reduction given by the seller of property to the buyer.
- Amounts from student loans discharged on the account of death or total and permanent disability of the student.
Form 1099-C
When a creditor cancels $600 or more in debt that you owe them, they are required to send you a Form 1099-C, Cancellation of Debt. This form serves the same function for cancelled debt as a W-2 does for an employee or a 1099-NEC for a self-employed individual. It reports the amount of your cancelled debt.
The creditor should send a copy to you and a copy to the IRS. If you get one, make sure you check that it is accurate. If it isn’t, contact your former creditor to get the issue resolved. The IRS will verify what you report on your tax return with the 1099-C that they receive. If the amounts don’t match, they will send you a notice.
It is possible that your creditor may not send you a 1099-C. You are still liable for the taxes owed on cancelled or discharged debt even if they don’t. It is your responsibility to accurately report your income, so make sure to include the taxable amount of your cancelled debts even if you don’t receive a 1099-C.
