Having large amounts of debt canceled is welcome news for most consumers because it frees up more money and eases financial stress. For proof, look no further than the 16 million Americans who signed up for the Biden administration’s federal student loan forgiveness plan before it was ultimately struck down by the U.S. Supreme Court. But canceling or settling debt also has certain tax consequences.
According to the IRS, if your debt is canceled, forgiven or discharged for less than the amount you must pay, the amount of the canceled debt is considered taxable and “you must report the canceled debt on your tax return for the year the cancellation occurs.”
This rule doesn’t apply every time, however. For example, the canceled debt isn’t taxable if the law “specifically allows you to exclude it from gross income.”
Many consumers seek debt relief because they are behind on their payments or no longer have the financial resources to pay it. As CNBC reported, debt relief companies help consumers negotiate lower debts either with the original creditor or a collection agency. You’ll have to pay a fee for the service, but it might be worth it if your settlement results in a large cancellation of debt.
There’s no guarantee that lenders will accept a settlement, but many do just as a way of cutting their losses, CNBC noted. Once a settlement has been reached and your debt is canceled, you could face a tax bill.
“You will be taxed on any forgiven debt over $600,” Leslie H. Tayne, founder of Tayne Law Group, told CNBC Select. “There are some exceptions, but even if you do end up paying taxes on [the forgiven debt], you’ll generally still be better off than if you had to pay the full sum.”
There’s a lot of legalese to wade through to determine which types of canceled debt are subject to taxation, and how much you’ll be taxed for. You can check this IRS page to learn more about the different scenarios and resources.
One thing you do need to know is that after a debt is canceled, the creditor might send you a Form 1099-C, Cancellation of Debt showing the amount of cancellation of debt and the date of cancellation. If you received a Form 1099-C showing incorrect information, be sure to contact the creditor to make corrections.
For example, if the creditor keeps trying to collect the debt even after sending you a Form 1099-C, the creditor might not have canceled the debt at all. However, your responsibility to report the taxable amount of canceled debt as income on your tax return “doesn’t change whether or not you receive a correct Form 1099-C,” the IRS stated.
You might not have to pay taxes on canceled debt if it falls under one of these categories, according to the IRS:
- Amounts canceled as gifts, bequests, devises, or inheritances.
- Certain qualified student loans canceled under the loan provisions that the loans would be canceled if you work for a certain period of time in certain professions for a broad class of employers, such as the Teacher Loan Forgiveness Program.
- Certain other education loan repayment or loan forgiveness programs to help provide health services in certain areas.
- Certain student loan discharges after Dec. 31, 2020, and before January 1, 2026.
- Amounts of canceled debt that would be deductible if you paid it as a cash basis taxpayer.
- A qualified purchase price reduction given by the seller of property to the buyer.
- Any amounts discharged from certain federal, private or educational student loans.
Keep in mind that there is a limit to the amount of debt that creditors are willing to settle. As Tayne told CNBC, it’s rare that you’ll be granted a settlement for five-figure sums.
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