What Is Cancellation of Debt?

Cancellation of Debt Explained in Less Than 5 Minutes

person in grey shirt working at computer while calculating bills on the desk
•••

mapodile / Getty Images

Debt cancellation is when an amount that you owe to a lender is forgiven or discharged. While you will no longer be responsible for paying back that amount of debt after it is canceled, there could be tax implications you need to know about.

Here’s how the cancellation of debt works, and how it could affect your taxes.

Definition and Examples of Cancellation of Debt (COD)

The cancellation of debt means that a lender has removed your obligation to pay back a debt, or at least a portion of it. Canceled debt can come as a result of negotiation with your creditors, debt relief programs, loan forgiveness, or through bankruptcy. If you own property subject to debt, cancellation may occur due to events like a repossession, foreclosure, or abandonment of property, to name a few.  

  • Alternate names: Debt forgiveness, discharge
  • Acronym: COD

How Does Cancellation of Debt Work?

The cancellation of debt is the result of a process that either the borrower or the lender initiates. It could be that a creditor is unable to collect a debt or part of the debt, and so they write it off. Or, the borrower may work with the creditor to negotiate the amount of debt owed either on their own, or through a debt relief company. Finally, debt may be canceled if the borrower qualifies for loan forgiveness, which is common when it comes to student loans. 

In most cases, if a cancellation of debt occurs, the amount is taxable and must be reported on your tax return. However, there are some exclusions that are specified by the IRS.

Reporting the Cancellation of Debt on IRS Form 1099-C

Any lender or creditor that cancels $600 or more of your debt will have to file Form 1099-C with the IRS, and send you a copy so you’ll have it come tax filing time. That amount of canceled debt is already being reported, so if you don’t include it on your taxes, you’re inviting a potential tax audit down the road. Therefore, any 1099-Cs that you receive must be included when you file your taxes. 

You will not receive a 1099-C for debts that are less than $600, but you still must report that debt when you file your taxes.

Do I Have to Pay Taxes on My Canceled Debt?

In most situations, canceled debt is considered income, and therefore you must pay taxes on it. For example, say you took out a personal loan for $10,000, but were unable to pay back the remaining $3,000 of it due to financial hardships. If you are able to successfully negotiate with the lender to cancel that remaining amount owed, the IRS considers that $3,000 to be income, since you were given funds that weren’t repaid.

In some cases, though, canceled debt will not be counted as taxable income. While you may still need to report the debt even if you qualify for one of the exceptions, it won’t affect your gross income.

You may qualify for an exception or exclusion if:

  • You file for bankruptcy: If a portion or all of your debt is discharged in bankruptcy, you may not have to include it as taxable income. This is because bankruptcy is intended to help you get back on your feet financially, and the last thing you need is an unexpected tax bill.
  • You are insolvent: Insolvency refers to situations in which a person owes more than their assets are worth. If this is the case for you, the IRS may allow you to exclude some or all of your canceled debt, but you’ll have to prove that you are insolvent.
  • A family or friend says you don’t have to pay back their loan: If your family or friend forgives a loan they made you, that debt typically does not have to go on your taxes. So if your Aunt Sally tells you that you don’t have to pay back the $2,000 she lent you for college, it would be considered a gift that you get to keep.
  • Interest on a canceled loan debt is tax-deductible: For some business or home mortgages that have tax-deductible interest, you only have to report the portion of the canceled debt that came from the principal owed. 
  • You qualify for certain student loan forgiveness: There are a couple of federal student loan forgiveness programs for teachers or those who perform certain kinds of service—and those types of canceled debt do not count. Also, if you become permanently disabled or someone passes away and their remaining student loans are discharged, that is not taxable income.
  • You’re eligible for a farm or real estate debt exclusion: There could be an IRS exclusion for certain debts involving farm or real estate, but there are specific eligibility requirements that must be met.

If the canceled debt does not fall under one of the exceptions above, then it will have to be reported on the “other income” line of your tax return.

Claiming an Exclusion With IRS Form 982 

If you want to claim an exclusion, there’s a form for that—Form 982. This form will serve as a paper trail that shows you were not responsible for paying income tax on the exact canceled debt amount. The official name of Form 982 is the Reduction of Tax Attributes Due to Discharge of Indebtedness. It helps taxpayers work out exactly how much canceled debt can be left out of their gross income.

Key Takeaways

  • The cancellation of debt is when a creditor or lender relieves a borrower from paying all or a portion of the debt obligation that they originally agreed upon.
  • Debt cancellation can come from loan forgiveness, a debt relief agreement, negotiating with your creditors, or through bankruptcy.
  • In most cases, canceled debt is considered taxable income by the IRS, and it must be reported.
  • There are some exceptions and exclusions to having to pay income tax on canceled debt, including some student loan forgiveness programs, bankruptcy, unpaid loans that come from family, and others.