The Basic Rule: Cancelled Debt Is Income
Under IRC Section 61(a)(11), gross income includes "income from discharge of indebtedness." When a creditor cancels, forgives, or settles a debt for less than the full amount, the IRS considers the difference to be income.
If a creditor cancels $600 or more of debt, they are required to file Form 1099-C (Cancellation of Debt) with the IRS and send you a copy. You must report this amount as "Other income" on your tax return.
Example: You owe $25,000 on a credit card. You settle for $12,500. The creditor issues a 1099-C for $12,500. If you are in the 22% tax bracket, you owe the IRS $2,750 on the "forgiven" debt.
This applies to all forms of debt cancellation outside of bankruptcy -- including settlements negotiated by debt settlement companies, hardship program write-offs, and charge-offs where the creditor stops collecting.
Exception 1: The Insolvency Exception
The most important exception for most people is the insolvency exception under IRC Section 108(a)(1)(B).
You are "insolvent" when your total liabilities (everything you owe) exceed your total assets (everything you own). The exclusion applies up to the amount of insolvency.
How to Calculate Insolvency
- Add up all your debts (mortgage, car loans, credit cards, medical bills, student loans, everything)
- Add up all your assets at fair market value (home equity, car value, bank accounts, retirement accounts, personal property)
- Subtract assets from liabilities. If the result is positive, you are insolvent by that amount.
Example: Total liabilities: $120,000. Total assets: $80,000. You are insolvent by $40,000. If $15,000 of credit card debt is forgiven, you can exclude the entire $15,000 because your insolvency ($40,000) exceeds the cancelled amount ($15,000).
To claim the insolvency exception, you must file IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) with your tax return. Check Box 1b and attach a worksheet showing your assets and liabilities.
Exception 2: Bankruptcy Discharge
Under IRC Section 108(a)(1)(A), debt discharged in a Title 11 bankruptcy case is completely excluded from gross income. This is a bright-line rule with no calculation required.
Key point: This exception applies to all debt discharged in bankruptcy -- not just credit card debt. And unlike the insolvency exception, there is no cap. Even if you have significant assets, the bankruptcy exclusion applies in full.
If you receive a 1099-C for debt that was discharged in bankruptcy, you still file Form 982 checking Box 1a -- but you do not owe any tax on it.
Tax Impact by Scenario
| Scenario | Amount forgiven | Tax bracket | Tax owed |
|---|---|---|---|
| Settlement, solvent | $15,000 | 22% | $3,300 |
| Settlement, insolvent by $15K+ | $15,000 | 22% | $0 |
| Settlement, insolvent by $8K | $15,000 | 22% | $1,540 (tax on $7K) |
| Chapter 7 discharge | $15,000 | Any | $0 |
| Chapter 13 discharge | $15,000 | Any | $0 |
Common Questions
What if I never received a 1099-C?
You are still legally required to report the cancelled debt as income, even if the creditor failed to send you a 1099-C. However, in practice, if no 1099-C was issued, the IRS may not flag the income.
What if the 1099-C amount is wrong?
Contact the creditor and request a corrected form. If they refuse, report the amount you believe is correct on your return and attach documentation.
Does the insolvency exception apply to retirement accounts?
This is a gray area. The IRS includes retirement accounts in assets for the insolvency calculation in some situations but not others. Publication 4681 provides guidance, but consult a tax professional for your specific situation.
What about state taxes?
Most states follow the federal treatment, but some do not. Check your state's rules. States that do not conform to IRC Section 108 may tax cancelled debt even when the federal government does not.
IRS Resources
- IRS Publication 4681 -- Canceled Debts, Foreclosures, Repossessions, and Abandonments
- IRS Form 982 -- Reduction of Tax Attributes Due to Discharge of Indebtedness
- IRS Topic 431 -- Canceled Debt: Is It Taxable or Not?