Tax Consequences of Settling Debt

Creditors often write off debts after a set amount of time, typically one, two, or three years after you default (stop paying). The creditor stops its collection efforts, declares the debt uncollectible, and reports it to the IRS as lost income to reduce its tax burden. The same is true when you negotiate a debt reduction.

If you settle a debt, such as a credit card debt, with a creditor for less than the full amount, or a creditor writes off a debt you owe, you might owe money to the IRS. The tax consequences of debt settlement include the IRS treating the forgiven debt as income—and you could owe federal income taxes.

Understanding the tax implications of debt settlement will help you avoid unwelcome surprises at tax time.

What Is Debt Settlement?

"Debt settlement" is an agreement between you and a creditor to pay less than you owe in one lump sum to satisfy the debt. For example, if you owe $10,000 on a credit card, and the creditor lets you pay off the balance for $4,000, that's a debt settlement because the creditor forgave $6,000.

What Are the Tax Consequences of Debt Settlement?

A creditor will report the amount you didn't pay because of a debt settlement to the IRS. Unless an exception or exclusion applies, the IRS will consider the canceled debt as taxable income to you. Of course, the IRS wants to collect tax on this money. So, you must report the canceled debt when you file your tax return for the year and possibly pay income taxes on it even though you didn't actually get any money.

Additional Tax Implications of Settling Debt

The additional income might also put you in a higher tax bracket, resulting in a larger tax bill. It might also affect your state taxes.

IRS Reporting of Canceled Debt on Form 1099-C

Any financial institution that forgives or writes off $600 or more of a debt's principal (the amount not attributable to interest or fees) must send you and the IRS a Form 1099-C at the end of the tax year. These forms are for reporting income, which means that when you file your tax return for the tax year in which your debt was settled or written off, the IRS will make sure that you report the amount as income.

Even if you don't get a Form 1099-C from a creditor, the creditor might have submitted one to the IRS. If you haven't listed the income on your tax return and the creditor has provided the information to the IRS, you could get a tax bill or, worse, an audit notice. This omission could end up costing you more in IRS interest and penalties in the long run.

How Much Taxes Do I Have to Pay on Forgiven Debt?

The amount you'll have to pay (and whether you'll have to pay anything) depends on your federal tax bracket and whether you qualify for an exception or exclusion. So, if your forgiven debt is $20,000 and you're in the 22% income bracket, you can expect to owe $4,400. The federal tax rates range from 10% to 37%, based on your taxable income and filing status.

What Are the Exceptions to the Tax Implications of Settling Debt?

The Internal Revenue Code has several reporting exceptions. For example, if the financial institution issues a Form 1099-C, you don't have to report the income on your tax return if you were insolvent before the creditor agreed to settle or write off the debt.

"Insolvency" means that your debts exceed the value of your assets. To figure out whether you were insolvent, you'll have to total up your assets and your debts, including the debt that was settled or written off. If the total of your debts is more than the value of your assets, then you're insolvent.

Can I Avoid Paying Taxes on Debt Settlement?

Here are a few examples of when you might be able to avoid paying all or some taxes after settling a debt.

If you conclude that your debts exceed the value of your assets (that is, you're insolvent), include IRS Form 982 with your tax return.

Other Exceptions Where Forgiven Debt Isn't Taxable

Here are some more examples of exceptions that could get you out of paying a larger tax bill:

• Generally, people working in particular professions for a defined period don't have to pay tax on canceled federal student loans. (See IRS Publication 4681.) Also, federal student loans discharged due to the student's death or permanent disability aren't taxable. In addition, the American Rescue Plan Act of 2021 made student debt cancellation tax-free at the federal level until January 1, 2026. (See § 9675.) So, from 2021 through 2025, forgiven student loans won't be included as part of your gross income for federal tax purposes.
• Amounts canceled as gifts, bequests, devises, or inheritances.
• Amounts of canceled debt that would be deductible if you, as a cash basis taxpayer, had paid it.
• You discharged the debt in bankruptcy.
• A qualified purchase price reduction given by the seller of property to the buyer.

More Exclusions

In addition, the following canceled debts are excluded from a taxpayer's gross income:

• cancellation of qualified farm indebtedness
• cancellation of qualified real property business indebtedness, and
• cancellation of qualified principal residence indebtedness discharged before January 1, 2026, or discharged subject to an arrangement you enter into (in writing) before January 1, 2026 (see "Forgiven Mortgage Debt After Foreclosure" below).

To learn more about the tax implications of canceled debt and learn more about the exceptions to cancellation of debt income, see IRS Topic no. 431, Canceled debt – Is it taxable or not?

You can also read IRS Publication 4681 to get information about the taxability of canceled debt, how to report it, and related exceptions and exclusions.

Forgiven Mortgage Debt After Foreclosure

Forgiven mortgage debt might be taxable after a foreclosure. In this situation, the law can seem especially cruel: Not only have you lost your property, but you might also have to pay income tax on the difference between what you originally owed the lender and what sold for at a foreclosure sale (called the "deficiency") if the deficiency is forgiven.

However, to keep financially strapped homeowners from taking a second hit at tax time, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007, and I.R.C. §108(a)(1)(E) was added to the Internal Revenue Code. This law created the Qualified Principal Residence Indebtedness (QPRI) exclusion. Under this exclusion, some taxpayers don't have to pay taxes for mortgage debt forgiven from 2007 through 2025, as well as debt discharged after that if a written agreement was entered into before January 1, 2026.

The exclusion provides tax relief if your deficiency stems from a foreclosure of your primary residence (the home you live in). It also applies to homeowners who've had mortgage debt forgiven after a loan modification, short sale, or deed in lieu. Here are the basic rules:

Loans for Your Primary Residence

If the loan was secured by your primary residence and was used to build, buy, or improve that house, you may generally exclude up to $750,000 ($375,000 if married and filing separately) as of December 31, 2020. Before this date, taxpayers could exclude $2 million ($1 million if you're married and filing separately) of forgiven debt.

So, if you qualify for the exclusion, you don't have to pay tax on the deficiency. The exclusion also applies to refinances, but only up to the amount of the original mortgage principal before the refinance.

Loans on Other Real Estate

If you default on a mortgage secured by property that isn't your primary residence—for example, a loan on your vacation home—you'll probably owe tax on any deficiency.

Loans Secured by But Not Used to Improve Primary Residence

If you take out a loan secured by your primary residence but use the money to take a vacation or send your child to college, you will likely owe tax on any deficiency.

How Does Settling a Debt Affect Your Credit?

Settling a debt can have both positive and negative consequences for your credit. On the positive side, settling a debt might help improve your credit scores because you've resolved a delinquent account. (The creditor or collector won't continue to report you as delinquent to the credit reporting agencies.)

However, when you settle a debt, it usually gets reported as "settled" or "paid for less than the full amount" on your credit reports. While this notation is better than having an unpaid or charged-off debt, the account's settled status might still hurt your credit because it suggests you couldn't pay the total amount. But if freeing yourself from having to pay a settled debt allows you to make other payments on time, your credit will eventually rebound.

Also, if you're able to work out a settlement for a debt, you can ask the creditor or collector to remove any negative information about the debt from your credit history. But be aware that if the creditor or debt collector deletes the tradeline, all information associated with the account will be removed, including any positive payment history you had before defaulting.

Talk to a Lawyer to Learn About the Tax Implications of Settling a Debt

If you need help handling the negotiations to settle your debts, consider hiring a debt settlement lawyer. If you have questions about whether a particular forgiven debt is taxable, consider talking to a tax attorney. And if you have a lot of debts, you might want to consider filing for bankruptcy. In that case, you'll want to talk to a bankruptcy lawyer.