If you have debt and your creditor cancels that debt, you feel like celebrating, right? This debt cancellation usually happens when the creditor forfeits collecting the debt or when the statute of limitations on collecting runs out.
A CPA in Playa Del Rey wants to remind you that debt cancellation comes with a trade-off. In most instances, a canceled debt is taxable, which means you may have to pay income tax on the canceled amount.
The Meaning of a Canceled Debt
A debt is canceled if the creditor forgives or discharges for less than the amount owed. The portion that you no longer need to pay is the canceled debt. This may result from repossessions, foreclosure, mortgage modifications, voluntary transfer of property, or property abandonment.
You will receive IRS Form 1099-C, Cancellation of Debt, from the lender when your debt is canceled. This form is also sent to the IRS by the creditor. The amount of debt shown on the 1099-C form as canceled is taxable income on your federal tax return unless you qualify for an exception.
When Do Banks Report Canceled Debt?
If your bank cancels your debt, the bank has to report it to the IRS. The IRS needs the bank to report debt cancellation due to a few “identifiable events.” The most common of these events are;
- A debt discharged in bankruptcy.
- Expiration of the statute of limitations for collecting a debt.
- Discontinuation of collection activity, whether based on a decision or as part of their defined policy.
- Other federal or state court proceedings that make a debt unenforceable.
- A negotiated settlement with the debtor.
A CPA in Playa Del Rey shares examples of some of the aforementioned events.
- Credit card debt forgiveness
- Mortgage debt forgiveness
- Student loan forgiveness
If you get a Form 1099-C detailing forgiven debt from a creditor, remember to report it on your federal income tax return and pay tax on the amount of canceled debt unless you meet an exception to this rule.
When is Debt Not Taxable?
There are a few situations when individuals are excluded from paying taxes for canceled debts.
1. Insolvency
The primary exception to paying tax on discharged debt is if you can show that you were insolvent when the debt was canceled. What does insolvency entail? To be insolvent means you have more debts than assets. If you cannot pay your bills and the bank cancels your debt, you probably qualify.
2. Bankruptcy
If your debts are discharged because you filed for Chapter 7 or 13 bankruptcy, it would mean you were insolvent and did not have to pay tax on debt cancellation. Here, you may exclude the canceled debt from your gross income.
3. Qualified Principal Residence Indebtedness
If you become indebted while purchasing, building, or improving your primary residence substantially, and it was forgiven before 1st January 2026, you can exclude it from your gross income. For tax purposes, your primary residence simply becomes your main residence where you live most of the time.
How Much Tax Do You Have to Pay on Debt Cancellation?
Paying tax on a canceled debt is much better than paying the entire balance. Canceled debt is taxed at the same rate as ordinary income. As a taxpayer, your tax rate depends on your tax bracket and can range between 10% and 37% depending on your taxable income. For instance, if you are in the 15% tax bracket and had a debt of $10,000 discharged, you may owe income taxes up to $1,500.
If you wish to learn more about canceled debt taxes, consult a CPA in Playa Del Rey.