There was an article that circulated recently suggesting that bankruptcies didn’t peak as expected. If the folks who are reaching out to me are any indication, just give it time. With unemployment numbers still high and many areas still under shutdown orders due to the pandemic, it’s clear that the economy is not back to normal. And one of the consequences of that economy is the inability of many consumers to pay off debt.

When you can’t pay off your debt, you may settle with the creditor for less than you owe. This can take a few forms, including short sales, foreclosures, or just agreeing with a credit card company to pay less than you owe if they stop chasing you for the balance.

No matter the form it takes, if you have cancellation of debt for less than the amount you owe, the amount of the canceled debt is considered income and may be taxable. I say “may” because there are exceptions and exclusions to this rule.

Form 1099-C

Here’s what you need to know. The lender or business owed the debt will sometimes issue Form 1099-C, Cancellation of Debt, to you for the forgiven amount. The IRS also gets a copy of Form 1099-C. The IRS will expect to see that amount reported on your tax return.

But what if you qualify for an exclusion or an exception? Even if you eligible for an exception or exclusion, you may still receive a form 1099-C. This is because the creditor doesn’t know whether you might have an exception or an exclusion: their responsibility is simply to report the details, including the amount of cancellation of debt and the date of cancellation. However, if the person who is issuing the form 1099-C has reason to know that the discharge of debt would not be reportable (such as, for example, a qualifying bankruptcy), then the form 1099-C shouldn’t be issued.

Exclusions & Exceptions

The most common exclusions include bankruptcy, insolvency, and qualified principal residence indebtedness.

If your debt was canceled as part of a Title 11 bankruptcy (includes Chapters 7, 11, and 13), it’s not includible in your income. To report the exclusion, attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), (downloads as a PDF) to your tax return and check the box at Part I, line 1a of the form. Enter the amount of canceled debt as a result of the bankruptcy case on line 2. You may also have to fill out part II of the form.

If you were insolvent just before your debt was canceled, you can exclude the debt from income. Use the insolvency worksheet (found in Pub 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) (downloads as a PDF), to figure out whether this applies to you. Generally, you are insolvent to the extent that the total of all of your liabilities was more than the value of all of your assets immediately before the cancellation. To report the exclusion, attach Form 982 to your tax return and check the box at Part I, line 1b of the form. Enter the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately before the cancellation (use the worksheet to find this figure). You may also have to fill out part II of the form.

If your canceled debt is qualified principal residence indebtedness, it’s not includible in your income. Qualified principal residence indebtedness means a mortgage that you took out to buy, build, or substantially improve your main home (the one you live in most of the time). The mortgage must be secured by your main home, and the amount available for exclusion must not exceed $2 million ($1 million if married filing separately). To report the exclusion, attach Form 982 to your tax return and check the box at Part I, line 1e of the form. Enter the amount of the forgiven mortgage on line 2 but do not report more than the amount of the exclusion limit. If you continue to own your home after cancellation of qualified principal residence indebtedness, you must reduce your basis (generally, the purchase price plus adjustments) in the home.

Special Circumstances

If you and another person were jointly and severally liable for a canceled debt, each of you may get a Form 1099-C showing the entire amount of the canceled debt. Don’t panic: you may not have to report that entire amount as income. The amount (if any) you must report depends on facts and circumstances, including state law, how much each of you received, how much of any interest deduction from the debt was claimed by each person (think home mortgage), how much basis was allocated to each of you, and whether the canceled debt qualifies for any other exceptions or exclusion.

If your student loan is canceled in part or in whole, you may not have to include the canceled debt in your income. To exclude canceled student loan debt from your income, your loan must have been made by a qualified lender to assist you in attending an eligible educational institution. In addition, the cancellation must be due to death or permanent and total disability, or as part of a provision in the loan that all or part of the debt will be canceled if you work for a certain period of time (like certain teaching or public service arrangements). The canceled debt is not excludable if it is canceled because of services you performed for the educational institution that made the loan or provided the funds.

Be Careful

The rules governing cancellation of debt can be tricky. It’s best to consider the consequences before you enter into an agreement to settle a debt for less than what you owe. But even if it’s after you make the decision – or if the decision is made for you – consider consulting with your tax professional.


Author’s Note: This piece focuses on consumers who can’t pay their bills. To find out more about the business side (when you’re the one owed), click here.

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Kelly Phillips Erb is a tax attorney, tax writer, and podcaster.

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