Debt forgiveness has become more accessible to many Americans, particularly for student loans. As of May 2024, the Biden administration had forgiven some amount of student loan debt for 4.75 million Americans, according to the U.S. Department of Education.
While that lifts a burden off many borrowers, a question remains: Is debt forgiveness taxable? If you’ve recently had a debt discharged, canceled or forgiven, make sure you know what your tax liability is to avoid any surprises.
[Read: Best Student Loan Refinance Lenders.]
Do You Have to Pay Taxes on Forgiven Debt?
When debt is forgiven you no longer have to worry about making monthly payments. But you may have to pay taxes on the forgiven debt. Borrowers who have had debts forgiven usually need to pay income tax on the amount forgiven, with a few exceptions. It depends on the situation and the type of 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.
Potential Exemptions and Exclusions
While debt forgiveness is typically taxable, per the IRS, there are some notable exceptions and exclusions.
— Your debt was canceled in bankruptcy. If you chose to file for Chapter 7 or 11 bankruptcy, any debts the court discharged in your case are not considered taxable. There is, however, a big exception, says Jeffrey Schneider, head of Florida-based SFS Tax & Accounting Services and The Tax Relief Co. “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.”
— 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. 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.
— You received a Paycheck Protection Program, or PPP, loan. Business owners who received a PPP loan through one of the COVID-19 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.
Is A Forgiven Student Loan Taxable?
Student loan forgiveness has become more accessible to Americans in recent years thanks to the expansion of loan forgiveness programs and other policies rolled out by the Biden administration.
But is a forgiven student loan taxable? The answer depends on why the debt was forgiven, and is subject to change. Here are some common scenarios and their tax liabilities.
— Your student loans were forgiven for public 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.
— Your student loans were forgiven under IDR. Federal income-driven repayment plans base monthly student loan payments on family size and income for affordability. When a borrower reaches the end of an IDR plan, any remaining balance is forgiven, and is typically subject to taxes. However, under the American Rescue Plan Act of 2021, any forgiveness on IDR plans is exempt from federal taxation until the end of 2025. So while you may get a time-sensitive break from federal taxation on this forgiven debt, you may still have tax liability at the state level.
— Your student loans were discharged because of permanent disability or death. The U.S. Department of Education will forgive your student loan balance if you die or become permanently disabled under Total and Permanent Disability discharge. Private student loan lenders may grant a disability discharge on a case-by-case basis. If your student debt was discharged due to disability any time from January 2018 through the end of 2025, it is not considered taxable income. However, debt discharged prior to 2018 may be subject to income tax.
[Read: Best Personal Loans.]
How Does Form 1099-C Affect Your Taxes?
If you’ve had $600 or more of debt forgiven or discharged by a lender, you should receive a Form 1099-C, or Cancellation of Debt, from the IRS. Lenders are generally required to send you and the IRS this form 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.
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.
“I always tell people: File and don’t pay, and we can work out the payments later,” says Schneider.
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 May 2024, plus the 0.5% failure-to-pay penalty each month or part of the month you have a balance, up to a max of 25%. 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 180 days.
A long-term installment plan can extend past 180 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 by mail only).
[Read: Best Debt Consolidation Loans.]
The Sooner You Prepare, the Better
If you’ve recently had any type of debt canceled, think about how it will affect your taxes. If the forgiven debt doesn’t qualify for an exemption or exclusion, you could owe income taxes on it.
Instead of waiting until Tax Day, figure out now if you 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 may also owe interest charges and penalties as you pay off your tax bill. Discuss the matter with a tax professional if you need additional guidance.
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Do You Owe Taxes on Debt Forgiveness? originally appeared on usnews.com
Update 06/04/24: This story was previously published at an earlier date and has been updated with new information.
