If you’ve recently received debt forgiveness, you may feel relieved that you will no longer have to worry about monthly payments. However, you’re not out of the woods just yet.
Borrowers who have debts forgiven must still pay income taxes on them. However, there are a few exceptions. Depending on the situation, those who qualify for exemptions can eliminate taxes on the canceled debt.
How Debt Forgiveness Works
Debt forgiveness occurs when a creditor or lender forgives some or all of a person’s outstanding credit or loan amount. While it sounds appealing, there’s usually a catch: your credit scores take a hit, and you’ll need to pay taxes on the forgiven amount.
One of the most popular forms of debt forgiveness is for credit cards. In situations where the person can’t pay the outstanding balance, the issuer sells the outstanding amount to another suitor, like a collection agency. From there, the agency starts the collection process, where they’ll attempt to call you about repayments.
Most collection agencies settle your debt with an amount that allows them to break even, along with an extra fee. However, as the borrower, you usually can negotiate to reduce the amount and have the rest forgiven. Once you receive debt forgiveness, you won’t be responsible for making payments.
There are also many forgiveness programs that the government funds to help Americans with some financial assistance. Typically, you’ll find student loan forgiveness or public service loan programs.
Keep in mind that debt forgiveness is different from debt settlement. Debt settlement is where you negotiate with the lender to pay a lower amount than you originally owed. However, debt forgiveness is when a lender wipes away some or all of the remainder of your owed amount.
What Canceled Debts Are Taxable?
The IRS classifies forgiven debt as income since the creditor or lender essentially “gave” you money to cover the outstanding amount. These terms intend to discourage delinquent borrowers from borrowing without paying it back. The most common forms of taxable canceled debt are for mortgages and credit cards.
Any forgiveness for your mortgage loan is considered taxable income. If your property has faced foreclosure, abandoned, or repossessed, the IRS views the cancellation of your mortgage as equivalent to a home sale. That means you’ll end up with a taxable capital gain.
Furthermore, canceled debt off of a short sale is considered taxable by the IRS. A short sale is when a distressed homeowner sells a home to a buyer searching for a bargain. The property value and the sale price are less than the total amount remaining on the owner’s mortgage. The lender can forgo the remaining debt when the property value is below the mortgage amount.
Credit Card Debt
Canceled credit card debt is typically reported as taxable income unless it’s resulted from bankruptcy or insolvency. However, in most cases, you’re expected to pay taxes on the canceled amount.
Taxpayers must report all canceled debt of at least $600 to the IRS. Expect to receive an IRS Form 1099-C, which states the amount the collector has canceled. This form indicates the amount you’ll need to report to the IRS. Failure to report this canceled debt could result in an audit or tax bill.
What Canceled Debts Are Exempt?
You can sometimes have canceled debts removed from your taxable income. Let’s look at the various exemptions and eligibility requirements.
Public Service Loans
College graduates who work with government or nonprofit organizations are typically eligible for various Public Service Loan Forgiveness programs. However, you’ll need to make 120 on-time payments on the loans while working for a qualified employer.
Those that meet those requirements can have the remainder of the loan canceled. Public service loan forgiveness and law school loan repayment assistance programs aren’t taxable.
Teachers who have worked for five consecutive years in educational service agencies or schools in low-income areas qualify for student loan debt forgiveness up to $17,500. Fortunately, canceled debt from teacher loan forgiveness programs isn’t taxable.
The American Rescue Plan Act allowed student loan forgiveness debt to be tax-free on the Federal Level regardless of the type of loan or program. That means all federal loans, such as Direct, Perkins, FFEL, and private loans forgiven before December 31, 2025, are tax-free.
How to Eliminate Taxes on Debt Forgiveness
There are many ways you can potentially “write off” taxes for your debt forgiveness. It’s advantageous if you’ve had your credit card or mortgage payments canceled, typically categorized as taxable income. Here are the various ways you can eliminate taxes on debt forgiveness.
The primary exception for paying taxes on canceled debt is if you prove that you were insolvent at the time of forgiveness. According to the IRS, taxpayers are insolvent when their liabilities exceed their assets.
For example, let’s say the creditor cancels your outstanding balance of $8,000 at a time when your only asset is $10,000, and your other debts total $20,000. In this case, you owe more money than you have, so you may qualify for an insolvency exclusion.
If you believe that you qualify under the insolvency exemption, you’ll need to report the market value of your assets and liability when your debt was discharged.
If you’ve filed for bankruptcy, all debts discharged by the course aren’t considered taxable. When your life is already in shambles, the IRS won’t put another tax liability on you.
However, the method of processing depends on whether you file for Chapter 7 or Chapter 13 bankruptcy. The latter requires you to undergo a repayment plan before you can have the remaining debt cleared.
Gift or Bequest
Let’s say you borrow money from a friend or family member, and sign a promissory note. The debt cancellation isn’t taxable if the friend relieves you of your obligation to repay the loan. The IRS won’t tax the forgiven amount as income in this scenario.
Will Debt Forgiveness Shows Up on Your Credit Report?
Debt forgiveness doesn’t show up on the credit report. After the cancelation, it’ll appear as settled on your credit report. When lenders and employers perform a hard pull on your credit history, they can’t see any details related to this.
Forgiveness effectively clears the item and shows it is settled on your credit report, so you’re no longer delinquent on payments. While it can temporarily damage your credit, it will recover over time.
Need Advice About Your Taxes? Contact Us!
While debt forgiveness relieves a lot of stress off your shoulders, it does come with the responsibility of paying taxes on the income received. Depending on the type of debt you have had canceled and your situation, there’s a chance you can eliminate taxes on it.
Tax laws are continuously changing, and one mistake in filing could cost you. The best way to eliminate taxes on debt forgiveness and avoid penalties is to hire a reliable accounting firm like MI Tax CPA. We work with you to reduce the taxes owed and improve your financial health.