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Is Debt Forgiveness Taxable?

Dena Standley | August 08, 2023

Dena Standley
Legal Expert, Paralegal
Dena Standley, BA

Dena Standley is a seasoned paralegal with more than 20 years of experience in legal research and writing, having received a certification as a Legal Assistant/Paralegal from Southern Technical College.

Edited by Hannah Locklear

Hannah Locklear
Editor at SoloSuit
Hannah Locklear, BA

Hannah Locklear is SoloSuit’s Marketing and Impact Manager. With an educational background in Linguistics, Spanish, and International Development from Brigham Young University, Hannah has also worked as a legal support specialist for several years.

Summary: When you settle a debt for less than what you originally owed, the IRS considers this taxable income. However, you may qualify for an exemption if you filed for bankruptcy, were insolvent during the settlement, or are eligible for student loan forgiveness. You may also be exempt from being taxed on canceled debt if the debt was forgiven as a gift or fits under a business/farm exclusion. Learn what situations require that you pay taxes on forgiven debt and what to do if you receive a 1099-C.

Typically, if your debt was forgiven or canceled by a lender, the amount forgiven is taxable. However, tax exemption is possible depending on your situation and the type of debt. If you qualify, you can eliminate or reduce the tax charges.

Generally, after your creditor forgives or cancels your debt, they must report it to you and the IRS through Form 1099–C. Once you’re aware of the forgiveness, you must put the canceled debt in the income section for tax purposes—unless you qualify for tax exemption.

So, how do you know whether you qualify for tax exemption? Which form will you use to explain your situation? Today, SoloSuit will answer these and other questions regarding debt forgiveness and tax exemption. Don’t like reading? Check out this video instead:

There are situations where you do not have to pay tax on a forgiven debt

The US tax codes require you to add any forgiven debt as an income and have it taxed because you received a particular benefit without paying for it. However, a few situations where you can get an exclusion from taxation and not be required to add it as an income are:

  • You filed for bankruptcy: Any debt the court discharged when you file for bankruptcy is not considered taxable. Moreover, if you file your tax return late, by even a day, the IRS will not exempt the canceled debt even if the court ordered the discharge.

  • You were broke during the cancellation (insolvent): If you can prove you couldn’t pay the debt due to being broke that year, you may qualify for an exemption. Although you have to fill out insolvency papers stating that you couldn't pay the debt due to severe financial constraints.

  • Your debt was forgiven as a gift: If a close friend or family member prefers not to collect a debt willingly, the IRS will not require you to add the debt in the income section.

  • Your canceled debt factors in tax-deductible interest: If the forgiven loan had accrued interest, you do not need to include the interest as income—though the principal amount is still taxable.

  • Your debt fits under a farm or business exclusion: Although the process can be complex and has several limitations, you can qualify for tax exemption if the forgiven debt is attached to your real estate property.

  • You qualified for student loan forgiveness: Students who qualify for tax exclusion must have been involved in a work program tailored to relieve student loan debt. Or your school closed, and you applied for a closed school debt discharge, and you became disabled and applied for the total and permanent disability discharge (TPD).

If you qualify for tax exemption on your forgiven debt, you must file form 982, determining the discharged indebtedness amount they can exclude from gross income.

What to do if you receive debt forgiveness

The worst thing to do is to ignore the matter and hide it from the IRS. Whether or not you receive Form 1009–C from your lender, you must report the forgiven debt in your tax returns. Basically, put it on line 21, containing the other income category.

When you qualify for tax exemption, fill out form 982 and, if possible, include a letter explaining why you are eligible for the tax exemption (optional). If you doubt you'll do it right, look for free or affordable tax counseling and tax preparation services in your state.

Let’s use Polly's situation to help us understand.

Example: Polly had a debt of $9,800 with First Federal Bank (FFB). After failing to pay for over a year and explaining her situation, they accepted her request for debt forgiveness. Within two weeks, Polly received form 1099–C from FFB. A friend told her she qualified for tax exemption after losing everything to a hurricane and using all she had left to start a new life. Next, Polly downloaded form 982, filled it out, and attached a letter explaining why she qualified for tax exemption on the forgiven debt. The IRS accepted her explanation after she included all her assets and liabilities, and they saw that her liabilities exceeded her assets by $7,200.

Is debt settlement an option for you?

Many debt collectors are willing to reach a debt settlement of less than the original amount owed. Why? Because many debt collectors purchase old debts for a small portion of the amount and try to collect in full to make a huge profit. Even settling for 50% of the debt can earn them a lot of money.

Debt settlement is a good option if you have some money but not the whole amount you owe. Besides, your taxable forgiven debt (the amount you owe minus the amount you settled to pay) will be less than if the entire debt was forgiven.

Use SoloSuit’s SoloSettle to request your creditors to settle the debt at a lower amount than you originally owe. This is a great way to start the negotiation process and avoid going to court if you’ve been sued.

That being said, make sure to file an Answer to your debt lawsuit before sending the Debt Lawsuit Settlement Letter. This will help you avoid a default judgment, which gives collectors the right to garnish your wages and seize your property.

To learn more about how to settle a debt, check out this video:

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