When a creditor forgives a debt in part or in full, you no longer have to worry about making monthly payments. But you may have to worry about paying taxes on the forgiven debt.
Borrowers who have had debts forgiven must pay income taxes on them, with few exceptions. If you’ve recently had a debt discharged, knowing whether it is taxable is important to avoid a surprise tax bill.
Do You Have to Pay Taxes on Forgiven Debt?
“If you’ve had debt forgiven by a creditor — even if only in part — the amount of your debt forgiveness will be taxable, unless you qualify for an exemption,” says Logan Allec, certified public accountant in Santa Clarita, California, and creator of the personal finance site Money Done Right.
Depending on the type of debt and the situation, you may be able to reduce or even eliminate the effect of the discharge on your tax bill. Here are some examples:
Your debt was canceled in bankruptcy. If your financial situation was dire and you chose to file for bankruptcy, any debts the court discharged in your case are not considered taxable.
“The idea is that if you’re going through bankruptcy, your life is already in shambles,” says Jeffrey Schneider, head of Florida-based SFS Tax & Accounting Services and The Tax Relief Co. “They’re not going to slap you again by putting a tax liability on you.”
There is, however, a big exception, says Schneider. “It is also the policy of the IRS that if you file any return late — even one day — they may not agree to the discharge, even if the bankruptcy court discharges it,” he adds. “In most cases, the Internal Revenue Code trumps all other courts.”
You were broke when your debts were canceled. Fortunately, being insolvent may reduce or eliminate your tax bill on the forgiven debts.
The IRS considers taxpayers to be insolvent if their liabilities exceed their assets. If you think you qualify under the insolvency exclusion, you will need to report the fair market value of your assets and liabilities just before your debt was discharged.
Make sure to include your retirement plan in your asset calculation, Schneider says. Once you’ve tallied up everything, subtract your assets from your liabilities.
Say your liabilities, including your forgiven debt, are $15,000, and your assets are worth $9,000. In this case, you’re insolvent, with liabilities exceeding assets by $6,000.
Your forgiven debt must be less than your liabilities to exclude it as taxable income. In this case, a forgiven debt of $5,000 but not $10,000 could be excluded, because it is less than the amount of your insolvency.
Many cases aren’t so clear-cut, though, and the IRS doesn’t provide a debt forgiveness tax calculator for insolvency. Allec recommends working with a tax professional if you think you qualify for an insolvency exemption.
Your debt qualifies under a business or farm exclusion. If the canceled debt was attached to your farm or real estate business and you meet other qualifications, the discharge amount qualifies for a special exclusion.
Your debt was canceled as a gift. Maybe a friend chooses not to collect a loan, or a family member forgives a debt in his or her will. When this happens, the IRS won’t tax the canceled debts as income.
Your forgiven debt includes tax-deductible interest. If a lender forgives a business loan or mortgage, you don’t need to report the interest as income because it would have been deductible anyway.
But you will still be on the hook for the canceled principal amount of the loan.
Your student loans were forgiven for service. Student loan debt canceled through the federal Public Service Loan Forgiveness program and others that require work in a particular field is not taxable income.
Note that this is not the same as forgiven student loans under federal income-driven repayment plans. Such plans base monthly student loan payments on family size and income for affordability.
When a borrower reaches the end of an income-driven repayment plan, any balance is forgiven but subject to taxes.
Your student loans were discharged because of permanent disability or death. The U.S. Department of Education and some private lenders will forgive your student loan balance if you die or become permanently disabled. The recent tax overhaul means that this canceled debt should not be considered taxable income through 2025.
You received a Paycheck Protection Program loan. Business owners who received a Paycheck Protection Program loan through one of the coronavirus relief bills may be eligible for forgiveness if they meet certain requirements. Under the Coronavirus Aid, Relief, and Economic Security Act, any amount that’s forgiven won’t be considered taxable income.
[Read: Best Personal Loans.]
What Is Tax Form 1099-C?
If a creditor discharged a debt of $600 or more, you should receive a Form 1099-C from the IRS showing the amount of debt forgiven for that tax year. In most cases, this is the amount you’ll need to include in your gross income — the sum of your earnings before taxes — when filing your tax return.
Even if you can exclude a forgiven debt from your taxable income, you may still get a 1099-C form. If this happens, you’ll use Form 982 to report the amount to exclude from your gross income based on your circumstances.
Once you know how much canceled debt to include as income, you will put that amount on Form 1040. Your canceled debt is now reported for the year it occurred.
How Does Form 1099-C Affect Your Taxes?
Your forgiven debt could mean a big tax bill, depending on your earnings, deductions and other factors. You also risk audits and penalties if you don’t file Form 1099-C with your federal income tax return.
Plan for taxes as soon as your debt is forgiven. And if you receive a 1099-C tax form, don’t ignore it.
“Even if the amount is less than $600 and a Form 1099-C is not received, the taxpayer is still required to report this income on their tax return,” Allec says.
Consider working with a tax professional to get an idea of how much more you might owe with the added income. You still need to file your taxes on time, even if you’re not sure you can pay the bill.
The IRS charges a failure-to-file penalty of 5% of the amount you owe for each month your return is late. The fine maxes out at 25%, and interest charges will apply on unpaid taxes.
“I always tell people: File and don’t pay, and we can work out the payments later,” Schneider says.
Can You Use an IRS Installment Agreement to Pay Tax on Canceled Debt?
You can use an IRS installment agreement if your forgiven debt leaves you with a huge tax bill you can’t pay. The IRS has two types of installment plans, but with either one, interest charges and failure-to-pay penalties will apply until you pay your bill in full.
You’ll pay 3% interest as of February 2021, plus the 0.25% failure-to-pay penalty each month or part of the month you have a balance, for up to five months. That said, these charges are less than the penalties for not filing your return and not paying.
You can choose either a short-term or long-term installment agreement. The short-term plan is ideal if you can pay off your tax bill within 120 days.
A long-term installment plan can extend past 120 days, but you could pay a setup fee of $31 to $225, depending on your income and plan. No setup fee applies to a short-term plan.
What to Do If You Paid Taxes on Debt That Qualified for an Exclusion
If you’ve had a debt forgiven in the past that you realize is eligible for an exclusion, you don’t need to resign yourself to losing that money. The IRS lets you amend your tax return for up to three years from the date you filed your original return or up to two years from the date you paid the tax, whichever is later.
You will gather your tax documents from that year and file Form 1040-X, which is an amended return.
In the process, make sure to include Form 982, explaining the exclusion you qualify for and the amount. Then, submit your amended tax return by mail; you can file amended returns only by mail.
[Read: Best Debt Consolidation Loans.]
The Sooner You Prepare, the Better
If you’ve recently had a debt canceled, think about how it will affect your taxes. Instead of waiting until Tax Day, you can figure out now if you will need to save anything and start working toward your goal.
If you wait until the last minute, not only will you stress more, but you will also owe interest charges and penalties as you pay off your tax bill.
More from U.S. News