Getting something you expected to pay for at a deep discount or even for free is exciting. In the case of forgiven debt, however, you may learn the deal wasn’t quite as good as you thought.
If a business cancels some or all of a debt you legitimately owe, you may have to pay income tax on the forgiven sum.
Here’s when a forgiven debt can trigger an extra income tax obligation and how to deal with it if it does.
What Is Forgiven Debt?
When you borrow money from a financial institution, you and the lender enter into a contractual payment arrangement. If you receive services from a business such as a dentist or utility company, you’ll get a bill for the services it provided. If you don’t pay the bill, a debt collector may purchase the unpaid account, and you’ll then owe that company.
Whether the debt is with the original company or a collector, it may be possible to have all or a portion of it canceled or forgiven. In that case, you’ll no longer owe the money to that lender, company or agency.
For instance, a collection agency may have acquired a hospital bill totaling $8,000. After negotiating with the collector, you were able to convince them to accept a lump sum of $1,000 to consider the case closed. After that, neither the hospital nor the collector can come after you for the $7,000 differential.
[Read: How to Negotiate With Debt Collectors]
Forgiven Debts That May Be Taxable
As wonderful as it can be to have all or some of your debt wiped away, in some cases, the IRS considers the forgiven amount income. Consequently, says Karla Dennis, an enrolled agent in La Palma, California, you may have to pay income taxes on that amount.
Examples of forgiven debt that can trigger a taxable event are:
— Reduced loan or credit card balance
— Settled collection agency debt
— Canceled bills for services rendered, like medical care
[How to Negotiate Debt With Your Credit Card Company]
Imagine you settle a bill resulting in a $7,000 forgiveness. You would add that figure to your other sources of income on that year’s tax return. Therefore, if your tax rate is 22%, you might pay an additional $1,540 in taxes. However, the forgiven debt may push your total taxable income to a higher tax bracket.
As an individual, you can settle a debt on your own, so you may not know about the tax issue. If you used a debt settlement company to negotiate the balance, it should inform you that the forgiven amount will be considered taxable income.
[READ: Can I Use AI to File My Taxes?]
Get Ready for IRS Form 1099-C
“When you have a debt canceled, be on the lookout for a 1099-C,” Dennis says. The company will issue the IRS form to people who have had their debts forgiven, whether completely or partially.
Creditors will send out Form 1099-C when the forgiven debt is $600 or more. Even if it falls under that threshold, if it qualifies as taxable income, you must still report it on your return.
You may not get the form immediately, so be proactive. Regardless of whether you received the 1099-C, add the forgiven sum to your income.
“When it comes to tax situations, forms don’t always come out timely, especially when we’re in recessionary periods,” Dennis says.
“I have seen situations where people have gotten their debt canceled in November or October of one year and then won’t get the form until the end of the next year after they’ve already filed their taxes,” she adds.
[READ: What Is a 1099 Form and What Should You Do With It?]
Forgiven Debts That Aren’t Taxable
The good news is that not all forgiven debt is considered a taxable event. For example, you won’t have to worry about the following canceled balances:
— Debts discharged in bankruptcy. After your debts are forgiven in bankruptcy court, they are gone for good. Those balances are not considered taxable income by the IRS.
— Settlement with the IRS. The IRS offers its own debt settlements — an offer in compromise — to certain financially stressed taxpayers. Income taxes will not be assessed on the forgiven portion.
— Federal student loans have been canceled. The Public Service Loan Forgiveness program canceled many borrowers’ student loan balances. The IRS has clarified that those borrowers will not be assessed income taxes on the canceled portion of their debt.
— Nonrecourse debt. A nonrecourse debt allows a lender to claim only the collateral on a secured loan. If the value of the collateralized property depreciates, the lender can’t come after you for the cash value difference, and the IRS will not consider that money as taxable income.
The Insolvency Exemption
Finding a Form 1099-C in the mail can be alarming when you thought a debt was long behind you. It may not seem fair that you’re being penalized for catching a much needed financial break. Recourse, however, may be available.
According to Kemberley Washington, a certified public accountant based in New Orleans, the IRS insolvency exclusion may help you avoid the extra cost even if the forgiven amount is taxable.
“A lot of people don’t know about the exclusion, and it can really help,” Washington says. “If you’re eligible, you can eliminate the taxable portion of your forgiven debt, which is good news for many taxpayers.”
As long as the total of your liabilities exceeds the value of your assets when your debt is canceled, you may claim the insolvency exemption. You still have to report the canceled debt as income on your return, but you will file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to receive the adjustment.
Don’t Guess, Get Assistance
When you’re faced with any unexpected taxable event, including one from a forgiven debt, reach out to an expert for guidance.
If you don’t have a CPA or other tax professional at your disposal, look into all the ways you can get free tax advice. Mistakes can be costly, so don’t wing it and hope you did everything right.
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Could You Owe Taxes on Forgiven Debt? How to Find Out originally appeared on usnews.com
Update 03/31/25: This story was published at an earlier date and has been updated with new information.
