Charles Trautman, EA · Since 1969
Settling a debt can come with a tax bill. Often it doesn’t have to.
When a lender forgives what you owe, the IRS generally treats the forgiven amount as income, as if you’d been handed the cash. A $6,000 credit card settlement can add $6,000 to your taxable income. But there are important exceptions, and the most useful one, insolvency, is the one people most often miss. Two big changes arrived in 2026 for homeowners and student loan borrowers.
For 2025 and 2026 returns. Current as of October 11, 2026.
Canceled debt shows up in many forms. Most lenders that forgive $600 or more send Form 1099-C, with a copy to the IRS. Even without a form, forgiven debt is income unless an exception applies.
You owed $10,000 and settled for $4,000. The $6,000 difference is canceled debt.
The lender sells the car for less than the loan balance and later writes off the shortfall.
Any part of a mortgage the lender forgives, including principal written down in a modification.
A loan forgiven by a relative out of affection is a gift, not income. A loan forgiven by an employer is usually wages.
Some forgiveness is never income: debt canceled as a gift or inheritance; an amount that would have been deductible if you’d paid it, such as a cash-basis business’s unpaid expenses; and a seller reducing what you owe on something you bought from them, which simply lowers your price.
These exclusions are claimed on Form 982, attached to your return. The price of using them is that certain tax benefits, like loss carryforwards or the cost basis of property, are reduced. For most individuals that cost is small or nothing.
If your debts were more than the value of everything you owned immediately before the debt was canceled, you exclude canceled debt up to the amount you were “underwater.” Everything counts on both sides, including retirement accounts and the debt being canceled.
Just before a $9,000 card settlement, Dana owed $62,000 in total and owned $50,000 of assets, counting her car and 401(k). She was insolvent by $12,000, so the whole $9,000 is excluded. Had the settlement been $15,000, $12,000 would be excluded and $3,000 taxed.
Debt discharged in a Title 11 bankruptcy case is never taxable. It applies before insolvency.
Qualified farm debt and qualified real property business debt have their own exclusions, with basis reductions instead of current tax.
For years, mortgage debt forgiven on your main home, up to $750,000, was excluded from income. That exclusion applied only to debt discharged before January 1, 2026. For a short sale, foreclosure or principal reduction in 2026, forgiven mortgage debt is taxable unless insolvency, bankruptcy or another exception applies.
If you’re personally liable, a foreclosure is treated as a sale at the home’s fair market value, and any debt forgiven above that value is canceled-debt income.
If the lender can only take the property, there’s no canceled-debt income. The whole loan balance is treated as the sale price instead.
A foreclosure or short sale is also a sale. Any gain on your main home is usually covered by the $250,000 / $500,000 exclusion. A loss on a personal home isn’t deductible. (See the home sale exclusion.)
From 2021 through 2025, almost all student loan forgiveness was tax-free under a temporary rule. That rule ended after 2025.
| Type of forgiveness | Taxable from 2026? |
|---|---|
| Public Service Loan Forgiveness | No. Permanently tax-free. |
| Teacher loan forgiveness and other programs that require work in certain jobs or areas | No. Permanently tax-free. |
| Death or total and permanent disability discharge | No. Permanently tax-free (a Social Security number is required on the return). |
| Income-driven repayment forgiveness after 20 or 25 years | Yes, federally, unless you’re insolvent. |
| Private loans settled for less than owed | Yes, unless insolvency or bankruptcy applies. |
A borrower who has $60,000 forgiven under an income-driven plan in 2026 adds $60,000 to taxable income. Many borrowers reaching forgiveness are insolvent, often because of the student loan itself, and can exclude much or all of it. Run the insolvency numbers before you file, and set money aside if you’re close to forgiveness. Because Colorado starts from federal taxable income, forgiveness that’s taxed federally is generally taxed in Colorado too. (See Paying for college.)
Lenders sometimes report the wrong amount, include interest and fees, or report a debt that was never actually forgiven. If the form is wrong, ask the lender to correct it, and we explain the difference on your return.
A 1099-C can arrive years after you stopped paying. What matters is the year the debt was actually canceled, which the form’s event code helps show.
The IRS matches 1099-Cs to returns. An unreported one leads to a CP2000 notice proposing tax, penalty and interest. (See Got a letter from the IRS?)
Possibly. The forgiven amount is income unless you were insolvent at the time, or the debt was discharged in bankruptcy. Many people who settle debts are insolvent, so check before you assume it’s taxable.
List everything you owned and everything you owed immediately before the cancellation, with values: bank accounts, vehicles, retirement accounts, home equity, and all debts. The IRS has an insolvency worksheet in Publication 4681. Keep the statements that back it up.
Federally, yes, for forgiveness after 2025, unless you’re insolvent. Public Service Loan Forgiveness remains tax-free. Plan ahead: estimate the tax and your insolvency position before the forgiveness date.
It can be. The exclusion for mortgage debt on a main home ended with 2025. Whether you have income depends on whether the loan was recourse, how much was forgiven, and whether you were insolvent.
Yes, if it was actually canceled and no exception applies. The lack of a form doesn’t make it nontaxable.
Don’t just add it to your income. Bring it in with a list of what you owed and what you owned at the time. Insolvency alone often takes most or all of it off your return. Taxes can be tough, but the Tax Shop has your back.