If you take out a loan with a legal obligation to repay a specific amount in the future, you have incurred a debt. This debt may be personally liable to you or secured by property you own, with or without personal liability.
When a portion or the entirety of a debt is forgiven, the forgiven amount is considered canceled. This can happen when a creditor is unable to collect the debt or decides to cease collection efforts. Cancellation may also occur due to foreclosure, repossession, voluntary transfer of the property to the lender, property abandonment, or mortgage modifications.
In most cases, canceled debt is considered taxable income and must be reported in the year it was forgiven. However, certain exceptions exist where canceled debt is not considered taxable income, which will be discussed later.
If your debt is canceled, the creditor may issue a Form 1099-C, Cancellation of Debt, outlining the amount forgiven and the date of cancellation. If you believe the information on this form is incorrect, contact the creditor for clarification. If the creditor continues collection efforts even after issuing Form 1099-C, the debt may not actually be canceled, and it might not be taxable income. Regardless of the form's accuracy, you are responsible for correctly reporting any taxable canceled debt.
Taxable canceled debt is generally reported as ordinary income on Form 1040, U.S. Individual Income Tax Return, Form 1040-SR, U.S. Tax Return for Seniors, or Form 1040-NR, U.S. Nonresident Alien Income Tax Return, using Schedule 1 (Form 1040), Additional Income and Adjustments to Income. If the canceled debt relates to a business, it must be reported on the appropriate business tax schedule.
Debt Secured by Property:
If the forgiven debt was secured by property and the lender takes possession of the property to satisfy the debt, it is considered a sale transaction for tax purposes. The treatment of this transaction depends on whether the debt was recourse (you were personally liable) or nonrecourse (you were not personally liable).
Recourse Debt: The sale price is considered the fair market value (FMV) of the property. Any difference between the FMV and your adjusted basis (usually the purchase price minus depreciation) results in a gain or loss. If the discharged debt exceeds the FMV of the property, the excess is taxable ordinary income unless an exclusion applies.
Nonrecourse Debt: The amount realized is the total outstanding debt, plus any cash or other property received. There is no ordinary income from debt cancellation in this scenario.
Example:
A business owner buys a boat for $20,000, with a $2,000 down payment and an $18,000 recourse loan. After paying off $4,000, they default on the loan. The boat dealer repossesses the boat, now worth $11,000, and forgives the remaining $3,000 balance. If the boat’s adjusted basis is $10,000 due to depreciation, the owner reports:
$3,000 in ordinary income from canceled debt ($14,000 remaining debt minus $11,000 FMV)
$1,000 gain on the sale ($11,000 FMV minus $10,000 adjusted basis)
For a nonrecourse loan under the same circumstances, the gain would be $4,000 ($14,000 debt minus $10,000 adjusted basis), with no ordinary income from debt cancellation.
Exceptions to Canceled Debt Income:
Certain types of canceled debt are not considered taxable income, including:
Gifts, inheritances, or bequests
Qualified student loans with forgiveness provisions for specific employment fields
Certain student loan discharges between December 31, 2020, and January 1, 2026
Debt forgiven under specific student loan repayment programs
Canceled debt that would have been deductible if paid under the cash method
Qualified purchase price reductions given by a seller
Exclusions from Gross Income:
In some cases, canceled debt can be excluded from taxable income, such as:
Debt discharged in a Title 11 bankruptcy case
Debt canceled due to insolvency
Qualified farm indebtedness cancellation
Qualified real property business indebtedness cancellation
Qualified principal residence indebtedness discharged before January 1, 2026, or under a written agreement before that date
If you exclude canceled debt from income using one of these exclusions, you must reduce certain tax attributes, such as credits, carryovers, and asset basis, by the excluded amount. You must report these exclusions and corresponding reductions on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), and attach it to your tax return. If you exclude canceled principal residence indebtedness, you must only reduce your home's basis. For qualified real property business indebtedness, only the basis of depreciable real property is reduced.