Short answer: if a lender forgives or settles your loan for less than you owe, the amount you no longer have to pay is generally taxable, and you report it for the year it was canceled (IRS Topic 431). There are exclusions, including debt canceled in bankruptcy and debt canceled while you were insolvent (26 U.S.C. 108(a)(1)). This page sums up IRS sources; it is not tax advice, so check your own case with a tax professional.
When a loan counts as canceled
- A debt is canceled for the amount that is forgiven or discharged for less than the full amount owed. This can happen when the lender can't collect, or gives up collecting (IRS).
- For a loan secured by property, such as a car, a repossession or voluntary transfer to the lender can also cancel debt, and is treated as a sale of the property (IRS).
- You report taxable canceled nonbusiness debt as ordinary income on your Form 1040, with Schedule 1 (IRS).
Form 1099-C
- After a debt is canceled, the creditor may send you Form 1099-C showing the amount and date (IRS).
- If the form is wrong, contact the creditor. If the creditor keeps trying to collect after sending it, the debt may not have been canceled (IRS).
- You must report the correct taxable amount whether or not the form is accurate (IRS).
The insolvency exclusion
You were insolvent to the extent your total liabilities were more than the fair market value of all your assets immediately before the cancellation. Assets include everything you own, including retirement accounts and property beyond creditors' reach (IRS Pub. 4681). You can exclude canceled debt only up to the amount you were insolvent (26 U.S.C. 108(a)(3)), you report it on Form 982, and you may have to reduce certain tax attributes (IRS). Pub. 4681 has an insolvency worksheet.
Worked example
Example, not tax advice: you owe $8,000.00 on a personal loan and settle it for $3,000.00. Canceled debt: $5,000.00. Assets immediately before the cancellation: $12,000.00. Two cases, figured the way Pub. 4681 does (IRS):
| Case | Total liabilities | Assets | Insolvent by | Excluded | Taxable |
|---|---|---|---|---|---|
| A | $20,000.00 | $12,000.00 | $8,000.00 | $5,000.00 | $0.00 |
| B | $14,000.00 | $12,000.00 | $2,000.00 | $2,000.00 | $3,000.00 |
In case B you would add $3,000.00 to income. If, as an example, that income were taxed at 12%, the extra tax would be about $360.00. Count this when you weigh a settlement offer.
What to do
- Get any settlement in writing, with the amount you pay and the amount forgiven.
- Keep a list of your assets and debts as of the day before the cancellation, in case you claim the insolvency exclusion.
- If an old debt is involved, see time-barred loan debt before you agree to pay anything.
- If you are weighing a new loan to pay off debts instead, see debt consolidation loans.
- If a debt collector makes the settlement offer, see debt collector rights on a loan.
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Disclosure: Modern Lending Solutions is not a lender, loan broker or agent for any lender or loan broker, and does not make credit decisions. Any compensation we receive is paid by participating lenders, only for advertising services. This guide is general information, not financial or legal advice.