(844) 845-4219 Default Image

Debt Settlement and Taxes » Debt Settlement » Debt Settlement and Taxes



When you settle your debt, you are agreeing to pay less than you owe. The remainder of what you owed before is now canceled debt. 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 income.

Most taxpayers know they pay income tax on their wages, or if they sell stock, or sell a house. However, many are unaware that the Internal Revenue Service (IRS) also levies income tax on canceled debts. The IRS treats canceled debt as part of your gross income, which increases your tax liability.  Unless you take action, you could be paying taxes on the debt you didn’t pay back during your debt settlement.

Why is settlement money 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 of debt forgiven. It’s essentially treated as if it were your 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 settled 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 as part of your gross income 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.

1099-C: Cancellation of Debt Form

When your debt is settled, the lender will send you a 1099-C tax form. This shows the specific taxable amount and how much you owe. If you don’t receive one, you can request it or use your own personal records. Is something wrong with your form? You can dispute it or send in a corrected version.

What about my mortgage?

Because of the Mortgage Debt Relief Act, you may be off the hook for canceled mortgages signed between 2007 and 2016. If your mortgage agreement was signed outside of these years, you may still be taxed for any part of it that was canceled.

How to qualify for an exclusion on debt canceled due to insolvency

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 settlement, you may be able to avoid tax on the canceled debt income.

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 insolvent 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, the IRS allowed an exclusion of up to $2,000,000 in canceled mortgage debt.  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.

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 to conduct an investigation into your tax situation. They can determine if you might qualify for some relief.

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

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 gone through debt settlement and it’s discharged, your work isn’t done.

The income tax levied on settled 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 state and federal taxes correctly for any year in which you settle a debt.

Knowing the types of canceled debt you can exclude and properly claiming it on your return can reduce the 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.’s trusted partners at Community Tax offer a free consultation and personalized tax investigation to determine if you qualify for an exclusion.

Get Help NowCall To Action Link

How Much Could You Save?

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