Cancelled Debt and Taxes: When You Will (and Won’t) Owe the IRS

October 7, 2025

Debt gets cancelled for all types of reasons – you may have paid off a chunk of credit card debt in exchange for having the entire amount written off, had a personal loan forgiven, or lost a home to foreclosure. While it was stressful to navigate, the worst is behind you — until you receive Form 1099-C in the mail, a tax form reporting your cancelled debt as taxable income.

If you’ve received a notice of cancelled debt, it’s possible that the IRS will view it as taxable income. However, there are cases where you don’t have to pay tax on the cancelled amount, even if it is reported on a Form 1099-C. To protect yourself from unnecessary tax bills and penalties, it’s critical to understand the rules.

Keep reading to find out when you owe taxes on cancelled debt, when you don’t, and how to proceed if you’ve received an unexpected tax bill.

Key Takeaways

If your debt is cancelled or forgiven, the lender may report it to the IRS on a Form 1099-C.
Failing to include your 1099-C on your tax return may result in adjustments to your return and tax debt.
Not all forgiven debt is taxable, so it’s important to discuss your case with a tax professional.
If your cancelled debt is non-taxable, you must report it on Form 982.

Why the IRS Treats Cancelled Debt as Income

In general, the IRS considers canceled debts a financial gain for the debtor. You received money (typically via a loan or line of credit), utilized the funds, and did not repay the full amount. This meets the definition of income according to IRS standards.

Legally, creditors and lenders are required to send you a 1099-C when they forgive or cancel more than $600 of debt. The IRS also receives a copy of this form, so even if you do not include it on your tax return, they know about it and will make the necessary adjustments to your return and tax bill.

Common Taxable Scenarios

There are many types of debt, but many forgiven or cancelled debts fit into a handful of scenarios:

Settled credit card debt, meaning you negotiated to pay it off for less than what you owed
Charged-off personal loans that the lender stops trying to collect and writes off
Foreclosures or short sales related to property loans and home mortgages.
Auto loans that have a remaining balance after repossession and sale of the vehicle
Private student loan forgiveness in some circumstances

To explain, imagine you owe $20,000 on a credit card, but the credit card issuer agrees to settle for $3000. The difference ($17,000) will be reported on a 1099-C and may be taxable income.

Do You Owe Taxes on Cancelled Debt? When Cancelled Debt Isn’t Taxable

The good news is that the IRS does allow exclusions. There are some situations where you don’t have to pay taxes on cancelled debt. Situations in which your cancelled debt may not be taxable include:

Bankruptcy discharge: Debt that is discharged as part of bankruptcy is typically not taxed. You can report this on Form 982.
Insolvency: If your liabilities exceeded your assets when the debt was cancelled, you may qualify for an insolvency exclusion.
Some farm or business debts: Certain business-related and farm-related debts may be non-taxable if they were linked to your trade or profession. However, you’ll likely need appropriate documentation—discuss this with your tax professional to see if your debt qualifies.
Qualified principal residence debt: This is a temporary exclusion that only applies to indebtedness discharge that is agreed upon prior to January 1, 2026.

There are other situations that do not result in taxable debt, including:

Debt cancelled as a gift or inheritance
Some student loans cancelled based on length of employment in a certain field
Some student loans discharged prior to January 1, 2026
Amounts forgiven under certain student loan repayment assistance programs
Canceled debt that would be deductible if a cash basis taxpayer had paid it
Purchase price reduction given to the buyer of a property by the seller of a property

The Paper Trail and How the IRS Finds Out

The IRS doesn’t need to guess about cancelled debt or rely on tips from third parties. They are notified directly by Form 1099-C. A borrower who files this form sends a copy to the payee (you) and the IRS. When your tax return comes through, the Automated Underreporter (AUR) program compares the information reported by third parties to the information included in your return. If there’s a discrepancy, your return is flagged, and the IRS will take further action.

The IRS often starts by sending CP2000, Notice of underreported income. If you agree with the amount or don’t respond to the notice, they then move on to CP3219A, a Notice of Deficiency. This includes the newly assessed taxes with qualifying penalties and interest. At that point, they can begin pursuing your tax debt via enforced collection actions.

Your Options If You Can’t Afford the Tax Bill

If the IRS says you owe taxes on cancelled debt and you can’t pay it, don’t panic. However, don’t ignore the problem, either. The sooner you take action and find the right solution for your situation, the less you ultimately spend on penalties and interest. Possible options include:

Installment agreement: If you owe less than $50,000, you can pay your tax debt off in monthly installments for up to ten years (or until your Collection Statute Expiration Date if sooner).
Offer in compromise: You may be able to settle your tax debt for less than you owe if what you can afford to pay is significantly less than what you owe. The IRS uses a formula to calculate this, and your minimum offer amount is based on your disposable income and assets. It’s fairly uncommon to get an offer approved, but if you fit the qualifications, it’s something worth exploring.
Currently not collectible status: This is a temporary form of tax relief that stops collection actions until your financial situation improves. If you’re approved, the IRS will periodically check to see if your financial situation has changed.

Form 982

This is the official IRS form used if you qualify to have your cancelled debt excluded from your taxable income. You submit your completed Form 982 to your tax return for the year in which the debt was cancelled. The form asks for the reason for your discharged debt and the amount excluded from gross income.

One topic that’s commonly misunderstood is insolvency as a reason for non-taxable cancelled debt. To be considered insolvent, you must calculate the fair market value of the assets you owned prior to the debt discharge and the debt you had prior to the discharge. You then subtract your debt from your assets. If your debt exceeded your assets at the time you received the settlement, you may be considered insolvent.

The non-taxable amount of your debt is dependent on how insolvent you were at the time of the discharge. For example, if your debt exceeded your assets by $10,000, you were insolvent to the extent of $10,000. If your forgiven debt was $15,000, you would only pay taxes on $5,000. The IRS includes a worksheet in Publication 4681 to help you calculate insolvency.

Real-Life Scenarios

These examples make the concept of taxable and non-taxable forgiven debt a little clearer:

You owed $15,000 in credit card debt, but ultimately settled for $7,500. You receive a 1099-C for the other $7,500. You were not insolvent at the time of the settled debt, and so you pay taxes on the full $7,500.
Your home was foreclosed on with a mortgage of $100,000. Depending on the timing of the foreclosure, you may not have to pay taxes on it because of the primary residence exclusion. But it also depends on the type of loan you have and the lender’s recourse for repayment.
You owed $4,000 on a personal loan and stopped payments, so the lender eventually stopped trying to collect. You were insolvent to the extent of $6,000 at the time, so the entire debt is non-taxable.

When It’s Time to Talk to a Tax Professional

If you’ve received a Form 1099-C and you aren’t sure how to proceed or if your debt is taxable, it’s time to talk to a tax professional. They can run through your tax transcript to ensure that the amount listed on the 1099-C is accurate, dig into the details of your finances to see if the debt is non-taxable, and help ensure that you file the correct forms.

This situation may be stressful, but you don’t have to navigate it alone. Let’s talk. Call Wiggam Law at (404) 233-9800 or contact us online to set up a consultation.

Cancelled Debt and Taxes Frequently Asked Questions

What’s the difference between cancelled and discharged debt?

Discharge typically refers to the legal release from debt and is usually used in the context of bankruptcy. Cancellation happens when a creditor agrees to forgive a debt, often outside the legal system.