If a debt is forgiven or discharged for less than you owe, the amount of debt that you don’t have to repay is considered to be cancelled. Cancelled debt can happen if the creditor or lender can’t collect, or if they have given up on collecting. Since in theory at least, having your debt cancelled provides an economic benefit it is taxable in many cases.
If you receive a 1099-C, then the IRS also will receive a 1099-C. The IRS will be expecting to see the taxable portion of cancelled debt reported on your tax return. If they don’t see it, at some point they will kindly remind you about it. Usually along with a request that you pay taxes, penalty, and interest.
There are some exceptions, so cancelled debt is not always taxed. For qualified mortgage debt on the principal residence up to $750,000 of cancelled debt (from 2021 to 2025) is excluded from taxation. Previous years had a $1 million limit.
The other common way to exclude cancelled debt from taxation is through insolvency. You are insolvent if your total debts exceed your total assets. If you are insolvent at the time of bankruptcy, the cancelled debt can be excluded from taxation up to the amount you are insolvent. The IRS provides an insolvency worksheet in Publication 4681.
Other cancelled debt that is excluded from income and taxation:
- Debt discharged through bankruptcy
- Qualified farm indebtedness
- Certain Qualified Student Loans
- Amounts of student loans discharged due to death or permanent disability.
There are some other cases when cancelled debt is excluded from taxation, so if none of the cases above apply to you consider doing some research in Publication 525 Taxable and Nontaxable Income and Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals)
One final point: Generally, you do need to enter cancelled debt information in your tax software and in the software determine if it is taxable or not.
