Do you pay taxes on debt forgiveness?

More than 1.2 million debt accounts were settled in the United States in 2022, with principal balances totaling $5.6 billion.

Debt forgiveness as a way of reducing crippling high debt offers one significant advantage — it can be preferable to bankruptcy. However, there are multiple drawbacks to this method of resolving your debt. One is the tax consequences of debt forgiveness.

What is debt forgiveness?

Through the debt forgiveness process, creditors and lenders pardon you from paying all or part of the outstanding debt you owe.

Debt forgiveness — also known as debt relief or debt cancellation — can be one way to resolve crippling balances on loans or credit cards.

Generally, debt is forgiven through negotiated settlements or repayment plans. If the debt involves federal student loans, government programs can help reduce the balance.

The main benefit of debt forgiveness is that you come out of the process owing far less to creditors and lenders. On the other hand, such programs require a lot of time and paperwork and may have stringent eligibility requirements. More often than not, debt forgiveness could knock down your credit score.

Then, there are tax implications for the settled debt.

What does the IRS say about debt forgiveness?

The old Benjamin Franklin adage about nothing being certain in life except death and taxes applies to debt forgiveness.

From the IRS perspective, “forgiven debts are typically considered taxable income and must be reported on your tax return,” said Karla Dennis, founder and CEO of full-service tax-strategy agency KDA Inc. “This is because the cancellation of a debt is considered income you otherwise would have had to repay.”

Specifically, the IRS classifies forgiven debt as gross income, meaning it’s taxed as ordinary income. Making the issue more complex, what you owe depends on your tax bracket, which depends on how much you earn in a given year, including your forgiven debt.

Here’s a closer look at how debt forgiveness amounts might impact owed taxes based on the 2024 federal income tax brackets and rates for various categories (for taxes due by April 2025).

Example #1 – Increased gross income

Let’s say you’re married and will be filing your joint tax return. Your joint income in 2024 totals $120,000 from salaries, putting you in the 22% tax bracket. Your income is taxed on a gradual basis based on the above brackets.

Here’s what it looks like in this example:

• Income up to $23,200 is taxed at 10%, totaling $2,320
• Income between $23,200 and $94,300 ($71,100) is taxed at 12%, totaling $8,532
• Income from $94,300 to $120,000 ($25,700) is taxed at 22% totaling $5,654

Adding up the above ($2,320 + $8,532 + $5,654) means you would owe the IRS a total of $16,506 in taxes.

Let’s also say that during 2024, you worked out a settlement with your lender in which $10,000 of debt would be forgiven. That’s $10,000 less you owe that lender. However, the IRS regards that $10,000 as additional taxable income, which amounts to an additional $2,200 in taxes at your top 22% tax rate.

So, while you’re not paying that $10,000 to your creditor, that forgiven debt generates an extra $2,200 in taxes. Once you account for this, the savings from canceled debt comes out to be $7,800.

Example #2 – A possible higher tax bracket

Your gross income, plus the amount of forgiven debt, could also place you in a higher tax bracket.

For example, if you and your spouse’s combined salaries totaled $93,000 in 2024, you would be in the 12% tax bracket. This means you owe the IRS $11,160 in taxes. Here’s how this breaks out:

• Income up to $23,200 is taxed at 10%, totaling $2,320
• Income between $23,200 and $93,000 ($69,800) is taxed at 12%, totaling $8,376

The above means that you owe the IRS $2,320 + $8,376 = $10,696.

Another thing you did in 2024 was work with a creditor who forgave $10,000 of debt you owed. This puts your taxable income at $103,000 (the $93,000 you earned plus the $10,000 in debt forgiveness). Additionally, more of your money is taxed at a higher amount, as follows:

• Income up to $23,200 is taxed at 10%, totaling $2,320
• Income between $23,200 and $94,300 ($71,100) is taxed at 12%, totaling $8,532
• Income between $94,300 and $103,000 ($8,700) is taxed at 22%, totaling $1,914

You owe the IRS $2,320 + $8,532 + $1,914 = $12,766.

This calculates to an extra $2,070 owed to the IRS with that debt forgiveness. Out of the $10,000 your lender forgave, you have $7,930 left.

A caveat with these examples is they don’t include itemized or standard deductions, which can lower your taxable income in the real world. However, the above demonstrates how forgiven debt can impact taxes when April 15 rolls around.

How do you report forgiven debt?

No matter the amount of the forgiven debt, the IRS requires you to report it.

When your debt is canceled, your creditor or lender should send you a Form 1099-C, Cancellation of Debt. This form shows how much was forgiven and the cancellation date, and creditors must issue it for any canceled debts over $600. However, you still have to report the canceled debt, even if your creditor doesn’t issue a 1099-C.

You’re required to take that information from Form 1099-C and report the forgiven debt as ordinary income on one of the following:

• Form 1040, U.S. Individual Income Tax Return
• Form 1040-SR, U.S. Tax Return for Seniors
• Form 1040-NR, U.S. Nonresident Alien Income Tax Return

That settled debt must be reported in the tax year in which it occurs. For example, if your debt was forgiven in 2024, you need to report it in your tax return for that year. Also, keep in mind that the above involves taxation at the federal level. Each state also has its own tax rules. Your forgiven debt could be subject to additional taxes.

What are the exceptions and exclusions to debt forgiveness?

Dennis explained that in most cases, taxed canceled debts include:

• Business debt
• Credit card debt
• Mortgage debts
• Personal loans

However, the IRS lists these exceptions on taxing forgiven debt:

• Amounts canceled as inheritances, gifts or bequests
• Amounts forgiven under some student loan repayment assistance programs
• Amounts of canceled debt that might be deductible if a cash-basis taxpayer had paid it
• Some student loan discharges after Dec. 31, 2020, and before Jan. 1, 2026

Additionally, the IRS excludes the following from gross income:

• Cancellation of qualified farm indebtedness
• Cancellation of qualified principal residence indebtedness discharged before Jan. 1, 2026
• Cancellation of real property business indebtedness
• Debts canceled through Chapter 11 bankruptcy
• Insolvency

If you feel your situation might qualify as a taxation exclusion or exception, Dennis suggests gathering the necessary paperwork to support your claim, such as insolvency worksheets, bankruptcy discharge papers or lender statements tied to student loan forgiveness. Furthermore, “complete and file IRS Form 982 if you are claiming insolvency, bankruptcy, qualified principal residence indebtedness or qualified farm indebtedness,” she said.

Once again, the above debt forgiveness exceptions and exclusions apply only to the federal level. Additional exclusions and exemptions could differ depending on your state of residence. “State laws can vary, so forgiven debt excluded from federal taxable income might still be taxable at the state level,” Dennis said.

Can you avoid taxes on forgiven debt?

Unless your situation falls under one of the exceptions mentioned above or exclusions, you should expect to pay taxes on the forgiven debt.

The best way to avoid paying these taxes is to consider alternatives when handling your debt. Some options include:

• Debt management plans involve a qualified credit counselor helping you set up a repayment plan and negotiating terms with your creditors.
• Consolidation loans, where you combine different debts into one new loan (and a single monthly payment) at a lower interest rate.
• Balance-transfer credit cards offer a 0 percent introduction annual percentage rate (APR) period, allowing you to save on interest if you pay the full amount by the end of the introductory period.

The bottom line

Embarking on a debt settlement or forgiveness plan eliminates some or all of what you owe. However, even if you owe less to a creditor or lender, you must pay the U.S. government.

If you decide to go the debt settlement route, work with a qualified CPA or tax preparation expert to fully understand the consequences, what needs to be filed, and how much you could owe.

Frequently asked questions

• What if my canceled debt isn’t considered taxable income?

  There are exclusions and exceptions to reporting forgiven debt as taxable income.
  
  
  Even if your situation falls under one of the many exclusions, the IRS still needs to know about it. This is accomplished by filing IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.

• I forgot to report the 1099-C on my tax return. Am I in trouble?

  You won’t end up in jail for forgetting to file paperwork. But you might need to file an amended return (Form 1040-X: Amended U.S. Individual Income Tax Return) to correct the situation. You might also need to pay any owed taxes (with penalties and interest) with that amended return if they weren’t paid on the original filing.

• Do I need to report forgiven debt even if I don’t receive a Form 1099-C?

  Yes. Unless the forgiven debt falls under one of the above-mentioned “exclusion” categories, you are required to report it as gross income to the IRS (and pay the taxes on it). Keep track of your dealings with creditors and lenders while working out a debt forgiveness plan.