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Cancellation of Debt (COD) » Cancellation of Debt (COD)



It may seem unfair that once you’ve canceled a debt it may come back to haunt you. But that’s the way the IRS works. They classify debt canceled through things like bankruptcy or debt settlement as taxable income because it’s credit you received but didn’t pay back.

The good news is that there are ways to get around the increased tax liability you could face in the year where you get a debt forgiven. Read on to learn how the IRS treats taxes on canceled debt and what you can do about it.

What is cancellation of debt (COD)?

Most taxpayers are aware that they have to pay income taxes on their wages, or if they sell stock, or sell a house. But many are unaware that the IRS also expects taxpayers to pay income taxes on canceled debts.

In formal terms, a “cancellation of debt (COD)” means that a lender has forgiven, canceled, or discharged your obligation to pay back a debt or a portion of it.

There are five scenarios where this can happen:

  1. A creditor is not able to collect a debt, so they write it off.
  2. You file bankruptcy and have your debts discharged.
  3. You’ve negotiated a settlement with the creditor or lender.
  4. You completed an income-driven student loan repayment plan and still have a balance left.
  5. You qualify for student loan forgiveness.

We’ll define each of these in more detail soon, but in any of these situations, the balance that was canceled or discharged becomes taxable income. The lender or creditor will provide you with IRS tax form 1099-C, which you must file with your annual tax returns..

How does canceled debt affect taxes?

When you first borrow money, you’re not paying tax on the money because you’re bound by a contract to pay it back. But if your debt is canceled, then you are receiving money for free in the IRS’s eyes. Basically, the cancellation of your obligation to pay back your loan becomes taxable income.

If you have $600 or more in canceled debt, it’s considered a taxable amount. Your lender is required to send you a 1099-C tax form. If your forgiven or discharged debt is less than $600, then you may not receive a 1099-C. However, you will still be required to report the canceled amount on your tax returns.

The creditor or lender will also send a copy of the 1099-C to the IRS. So, if you do not acknowledge the form and income on your annual income tax return for that year, it would raise a huge red flag. It could result in you getting audited.

Methods of canceling debt

There are many different methods for you to cancel some or all of your debts. What is best for you all depends on your circumstances and what you are able to afford. It also always smart to seek legal advice before proceeding.

Negotiating with creditors

This is fairly straightforward. A borrower contacts their lender and asks them to forgive some or all of their debt. Or a borrower might negotiate to pay a smaller amount upfront. Debt negotiation can be a great way to avoid paying at least a portion of the debt, but you’ll need a solid chunk of change to do this.

Those who have no savings to fall back on are at the mercy of a lender. And getting lenders to knock off any penalties or late fees can be difficult because that is their primary source of income. But, in most cases, this is still the simplest and cheapest method of dealing with indebtedness.

Debt relief programs

There are a multitude of debt relief programs available throughout the country, including debt settlement programs that settle debt for less than the borrower owes.

Debt settlement companies negotiate directly with the borrower’s creditors to get them to accept a percentage of the amount owed. Once a settlement is reached, the creditor gets paid what was agreed and the remaining balance gets forgiven.

That forgiven amount then becomes taxable income.

Student loan repayment and forgiveness programs

Options for student loan forgiveness depend on factors like income, the kind of work you do, and the amount you owe.

Programs that outright forgive or cancel student loan debts can be hard to come by and even harder to qualify for. But these programs will forgive all or some of your remaining federal student loan balances once you meet the qualification criteria.

However, there are also income-driven repayment plans that forgive remaining balances once you complete the repayment term. You make payments for 20-30 years with these programs, but then once you complete make all the payments, any remaining balances owed are forgiven.

Only certain types of student loan debt cancellation will be counted as taxable income. To help simplify things, we made a table that breaks down eligibility and whether or not you owe taxes:

ProgramEligibilityDo I owe taxes?
Public Service Loan ForgivenessIf you have worked for the government, or a qualifying nonprofit, and made 120 payments while employed thereNo
Revised Pay as You EarnIf you have a remaining balance after being on a 20-year undergraduate plan or a 25-year graduate planYes
Pay as You EarnIf you have a remaining balance after being on a 20-year planYes
Income-based RepaymentIf you still have a remaining balance after being on a plan for 20 years for new borrowers on or after July 1, 2014; or 25 years if you were not a new borrower at the timeYes
Income-contingent RepaymentIf you have a remaining balance after being on a plan for 25 yearsYes
Teacher Loan ForgivenessIf you have taught for five complete, consecutive academic years in a low-income area, you may be eligible for up to $17,500 in forgivenessNo
Student Loan Repayment AssistanceIf you received help repaying loans because of participation in National Health Service Corps Loan Repayments Program, or a state program related to providing health services in underserved areasNo


Bankruptcy is a legal process that can absolve a borrower from repaying most of their debts. Some exceptions are back taxes, court-ordered payments, and most student loans. It also grants you an automatic stay that prevents lenders from pursuing any further collection efforts.

No matter which chapter of bankruptcy you file, most of your debts will be discharged once you fulfill the requirements of your bankruptcy.

Exceptions to cancelation of debt income

For the most part, canceled debts are considered taxable. However, there are a few exceptions to the rule. If you find yourself in one of the following situations—you may still have to report your debt—but it will not be counted toward your gross income.

In some cases, you will need to file an additional form to claim an exclusion. In others, no additional tax paperwork is necessary.

Claiming an exclusion with IRS Form 982

If you are a farmer—who has earned at least half of your income from the farm within the last three tax years prior to the current tax year—and have farm-related debt forgiven, you will not be required to include your canceled debt in your income.

If you have debt from business real estate canceled, you also would not owe any taxes.

In both cases, you will need to file a Form 982, the Reduction of Tax Attributes Due to Discharge of Indebtedness to claim this exclusion.


If your debt was discharged in a Title 11 bankruptcy (like Chapter 7 or Chapter 13), you would not be responsible for taxes on that debt. However, it may be best to consult with your bankruptcy lawyer to figure out whether you need to claim 1099-C income relevant to your bankruptcy charge.


Debts forgiven through debt settlement or a debt relief program may also qualify for an exclusion. However, you must be able to demonstrate you were “insolvent” at the time the debt was forgiven.

If the total amount of your debts—including any forgiven debt—is greater than your total assets, then you will not be required to pay taxes on your canceled debt up to the insolvent amount.

You will need to file a Form 982 to qualify for the exclusion.


If a friend or family member lends you some money and tells you not to worry about paying them back, then the IRS will look at this type of debt cancellation as a gift. Because the lump sum of money is given with no expectation of it being paid back partially or in full. Therefore, your benefactor isn’t required to issue you a Form 1099-C, and you aren’t required to report it as income.

Tax-deductible interest

If you have had business or mortgage loans canceled, you would not need to report the forgiven amount so long as the interest was considered tax-deductible. However, you will still be on the hook for your canceled principal amount.

Certain student loans

Debt forgiven through student loan forgiveness programs are generally treated as income. So, you may still owe taxes on forgiven debt. For example, if your federal student loan balance is forgiven while you’re on an income-driven repayment plan, you may still owe taxes on the forgiven amount unless you qualify for a different exception.

However, if your student loan balances are forgiven as part of the Public Service Loan Forgiveness program, you will not be required to report that forgiven debt as income.

Additionally, due to changes from the Tax Cuts and Jobs Act, if your federal student loans are discharged because you have become disable, your canceled debt does not need to be included as income.

Real estate or farm

There are two ways your home may qualify for the exclusion. If a seller provides a qualified purchase price reduction on a property. Also, the Home Affordable Modification Program allows for Pay-For-Performance Success payments which lower the principal balance on a mortgage.

Although considered canceled debt, the IRS does not require qualified farm indebtedness, qualified principal residence indebtedness, or qualified real property business indebtedness to be reported as income.  Therefore, it may be excluded.

Why is canceled debt taxable?

If a creditor decides to forgive an overdue credit card balance, if a vehicle is repossessed to partially satisfy a secured vehicle loan, or if a mortgage company forgives mortgage debt after a foreclosure, the taxpayer is on the hook for income tax for the amount forgiven. It’s essentially treated as if it were regular income, because it’s money you borrowed that you’re no longer obligated to pay back.

If you settle large amounts of debt, the tax bill can easily run to thousands or tens of thousands of dollars in additional tax. You could lose your refund or worse, you could end up owing the IRS and facing new challenges with tax debt.

Income tax on canceled debts often operates as a “double penalty.”  Financial difficulties are typically the root cause of credit card debt, repossession and foreclosure. So, an extra tax bill on any forgiven debt adds a financial burden to someone already experiencing hardship. But there is some good news – IRS allows taxpayers to exclude canceled debt income (i.e. no extra tax due on canceled debt) under certain conditions.

Can you qualify for an exclusion on canceled debt?

Release your finances from being tied up in back taxes by cutting out a tax debt forgiveness plan

IRS will exclude canceled debt if the discharge occurs for:

  • a bankruptcy case
  • qualified principal residence indebtedness
  • insolvent taxpayers to the extent they are insolvent
  • qualified farm indebtedness
  • qualified real property business indebtedness

The two most common situations are when the taxpayer is insolvent and for qualified principal residence indebtedness. The IRS considers a taxpayer when their total liabilities exceed their total assets.

Filing an exclusion for the cancellation of debt due to insolvency

Applying for the insolvency exclusion involves filling out a form detailing all the taxpayer’s liabilities and assets (see IRS publication 4681). The IRS allows taxpayers to exclude canceled debt in an amount equal to how much their liabilities exceeded their assets.

For example, if a taxpayer has $10,000 in liabilities and $7,000 in assets, that taxpayer can exclude the difference; they qualify for forgiveness for up to $3,000 in canceled debt. The tax on $3,000 could up to almost $1,200. So, claiming this exclusion can make a big difference on the tax return’s bottom line.

Filing an exclusion for principal residence indebtedness

The second most common canceled debt exclusion is for qualified principal residence indebtedness. A qualified principal residence is your “primary home” that you live in most of the time. This type of cancellation most commonly happens when the lender agrees to a short sale or starts a foreclosure action.

Until 2016, IRS allowed an exclusion of up to $2,000,000 in canceled mortgage debt arising from foreclosure or short sales of taxpayers’ principal residences. This exclusion allowed the vast majority of taxpayers forced into foreclosure or short sales to escape the “double penalty” of a tax bill for any unpaid mortgage debt.

However, beginning in 2017 the IRS dialed back the exclusion. Now, the IRS now only allows the exclusion if the discharge was “subject to an arrangement that was entered into and evidence in writing before January 1, 2018” (See Instructions to form 982). So, while this provision has provided immeasurable relief over the past 10 years, it may not exist much longer.

It pays to work with a tax expert when it comes to canceled debt

Tax debt consolidation offers faster relief

People often think forgiveness on loans or credit card debts is the end of your troubles. You paid as agreed, so you can breathe easy. But once you’ve settled debt and it’s been discharged by the creditor, lender or collector, your work isn’t done.

The income tax levied on canceled debt can be a serious burden for taxpayers already in financial distress. You wouldn’t be settling debt and taking credit score damage if you had the means to pay. So, it’s critical to file your taxes correctly for any years where you settle a debt.

By knowing which types of canceled debt income you can exclude and by properly claiming it on your tax return, you can reduce or eliminate the “double penalty”.  However, you must know how to file canceled debt on tax return forms to avoid liability.

The key is to have an experienced tax preparer on your side. You need someone to guide you through the process and ensure you are not overpaying.  Without guidance, it is easy to fall prey to the “double penalty” of tax on canceled debt.

Tax trouble? Contact us today.

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 Expert answers to canceled debt questions

Taxes on written-off credit card debt

Question: I had a rough patch in my life and succeeded in getting some credit card debt “written off.” I thought this meant I didn’t have to pay anything.

But now I got a letter from the IRS saying I have to pay income tax! On the forgiven debt! How is DEBT considered to be INCOME? If I had income, I wouldn’t be in debt! SMH!

This is ridiculous! Can you explain this to me? Is it even legit? Or am I being scammed? If it’s true, what can I do? I’m nearly broke as it is, and I was actually thinking about bankruptcy. Would that help?

– Moses in California

Jacob Dayan answers…

That is a great question, and I completely understand your frustration. I know it can seem almost like a cruel joke being played on you. But unfortunately this is not a scam. When credit card debt is forgiven, it’s rarely a simple process. Here’s a quick video primer…

Video Transcript

Hi, I’m Jacob Dayan, the CEO and Co-founder of Community Tax. That is a great question, the answer to your question is relatively straightforward, but as always, I have to caution you that everyone’s tax circumstance is different. As such, it’s often advisable to speak with a tax professional prior to making a decision related to this. Before I break down the answer, let’s review some basics about collections and taxes.

The short answer is that a credit card company will write off a debtor’s balance after months if not years of collection efforts. The credit card company will issue the debtor a 1099 cancellation of debt. What this means, is that the debtor – you – are then required to pay back income tax on the amount that was canceled or forgiven.

The IRS essentially treats any unpaid, forgiven debt as income. And you definitely don’t want to ignore the IRS. If you want to know more about what happens if you do, read the report Understanding the IRS Collections Process available on There is, however, an exception to the requirement of paying taxes on any canceled credit card debt.

The taxpayer will not be responsible for paying taxes if they can prove they are insolvent at, or before, the cancellation of debt. Insolvent means that you have no assets or that your financial situation is basically upside down. Credit card companies will generally wait three years before issuing a 1099 cancellation of debt. Why? Because they must show a consistent attempt to collect the unpaid balance. Credit card companies are not in the litigation business. So, they tend to sell past due accounts to law firms that will collect on the outstanding debt.

If a credit card company fails to collect after roughly six months, they may engage a collections law firm to take over collections. The law firm will try to work out payments of the debt prior to filing suit in a civil court. After three years of attempting to collect, the credit card company will finally write off the debt and issue a 1099 cancellation of debt. I hope this helped clear things up. If you have any other questions, feel free to give myself or my team a call, or visit

Now let’s dig into Moses’ particulars.

Yes, debts can be taxable

Under IRS guidelines, canceled debt counts as taxable income. In ordinary circumstances, receiving a loan is not considered income, and paying it back is not a deduction. But when a lender cancels the debt, the IRS treats the amount of canceled debt as if it is indeed taxable income.

There are exceptions

This is one of the harshest provisions in the tax code because it punishes folks who are already struggling. But there may be help! There are some instances when this “canceled debt income” can be excluded from income, and you can escape tax on it.

For example, if the canceled credit card debt was from a bankruptcy, or if you can prove to the IRS that you owed more total debt than the value of your assets (home, car, retirement accounts, etc.) at the time of the forgiveness, you may be able to avoid tax on the canceled debt income.

Resolution programs

The IRS also has resolution programs specifically designed for those with financial difficulties — such as a payment plan, “Currently Not Collectible” hardship status, or a settlement if you qualify. If you would like more information, we have tax professionals on staff who can conduct an investigation into your tax situation and determine if you might qualify for some relief.

Jacob Dayan is co-founder of Community Tax LLC, a full-service tax company helping customers nationwide with tax resolution, tax preparation, bookkeeping, and accounting.

Let us connect you to the right solution for your tax debt.

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Taxes after loan modification

Question: I entered into a loan modification five years ago under HARP. The modification was not honored by my lender, and I had to sue. The result of the suit was my lender reduced the principal of my loan by $115,000, and they sent me a form called 1099-C. Do I really have to pay taxes on this?

William in California

Howard Dvorkin, chairman and CPA, responds…

HARP stands for Home Affordable Refinance Program, and since it launched in 2009, it’s been the government’s most popular program for refinancing mortgages. Why? Because HARP is designed for homeowners who are “underwater” – meaning they owe more on their mortgages than their homes are worth.

There are a bunch of rules for qualifying – loan-to-value ratio must be 80 percent, etc. – but what’s important for William and other HARP participants to know is this: Yup, taxes can become an issue.

Canceled debt is considered income

Like every other government program, complications abound. So I consulted two other financial experts who have sharp insights into William’s question.

“In many cases, when a lender cancels a portion — or all — of an outstanding balance, you usually have to consider that canceled debt as income and report it on your tax return for the year in which the debt was canceled,” says Crissinda Ponder, Staff Writer at LendingTree. “However, there are instances when the canceled debt can be excluded from your taxable income. One of those possible exclusions is a loan modification on your primary home. Since the principal balance on your mortgage has been reduced, you may qualify to exclude the $115,000 from your taxable income.”

So as you can see, the answer is: Yes, you must pay taxes – except when you don’t.

When you do, you need the tax form William mentioned. The IRS calls it a 1099-C. If the canceled debt is at least $600, you must fill one out. This form lists important information about the canceled debt, including the amount owed and the cancellation date.

More information on form 1099-C

For more on the 1099-C, I consulted Jacob Dayan. He’s the co-founder of Community Tax, one of the best tax consulting firms I’ve ever worked with.

Dayan says if the property is your principal residence, and the forgiven loan principal was part of an “arrangement entered into before January 1, 2018, or earlier,” you likely will not need to pay tax on the $115,000.  But, he says…

“If the home was not your principal residence, or the arrangement to forgive part of the loan principal was entered into in 2018 or 2019, then you likely owe income tax on the full $115,000. In general, there are no tax consequences for a loan. The borrower does not report the borrowed funds as income and does not report a deduction when the borrowed funds are paid back.  However, when a loan is forgiven the tax consequences change and the amount of forgiven debt is taxable to the borrower.”

Why is it so complicated?

There’s a reason for all this back-and-forth. When the home mortgage crisis gripped the country starting in 2007, Congress enacted a provision to allow homeowners to exclude canceled debt as income (meaning no tax) as long as the canceled debt was for their principal residence.

But beginning in 2018, the government scaled back that provision significantly. For the tax years 2018 and beyond, Dayan says this: “To be excludable the discharged debt must, first, cover a mortgage on your principal residence and, second, the arrangement for the forgiven loan principal must be in writing and dated before January 1, 2018.”

He continues: “if the loan covered your principal residence and the agreement to forgive the principal occurred before January 1, 2018, you will be able to exclude the $115,000 on the 1099-C and pay no tax.  But if this was a rental property or second home, and the agreement to forgive the loan principal happened on January 1, 2018, or after, you will be stuck paying tax on the full $115,000.”

Consult a tax expert

If it confuses and confounds you, then my expert advice is this: Consult a tax expert like Jacob Dayan. In almost every case, you’ll save significantly more on your taxes than you’ll pay for the expert advice. As you can see, tax questions can easily get complicated. It often requires an expert to unspool the details – and find you the savings.

How Much Could You Save?

Just tell us how much you owe, in total, and we’ll estimate your new consolidated monthly payment.