Tax Consequences of Debt Relief Services

    Questions asked about Tax ConsequencesIf you used debt relief options – specifically, debt settlement – to escape severe financial problems last year, you’re probably still celebrating your good fortune.

    Slow down. The IRS has their eye on you. They might want to tax the money you thought you saved, which means your troubles might not be over after all.

    If you receive a 1099-C tax form – sent from lenders to borrowers who had $600 or more of debt canceled during the year – you must claim the amount shown on your 1099-C tax form as income for the year. The IRS predicts that more than four million taxpayers will get a 1099-C tax form in 2018, so if you had debt forgiven, be on the lookout or you could be at risk of getting fines, penalties or maybe even an audit from the IRS.

    Maximum Tax Refund Turbo Tax

    Yes, that $10,000 in credit card debt you had forgiven, or the $50,000 of debt you thought you avoided after a short sale could end up on Line 21 of your next tax return as “Other Income” and on Line 43 as part of your “Taxable Income.”

    The IRS treats the debt you had forgiven the same way it does the money you get in your weekly paycheck – as income, subject to taxes that you must pay.

    “It’s easy for people to forget they are on the hook for taxes when they don’t receive any cash from a debt settlement,” Bruce McClary, vice president for the National Foundation for Credit Counseling, said. “Not getting cash just makes it harder to make a connection that the settled amount is actually considered income.”

    Now before you run out and scream, remember we’re talking Internal Revenue Service rules and there are as many exceptions to the rule about forgiven debt as there are rules that punish those who thought they caught a break.

    Stay with us and find out which category – taxed or untaxed – your canceled debt falls in.

    Forgiven Debt that is Taxable

    This area belongs almost exclusively to the debt settlement domain, but also could include personal loans you default on. Here are examples of both

    Suppose you have $25,000 in credit card debt and choose a debt settlement program to get the number down where you could actually pay it off. The debt settlement company comes back with good news that if you pay $15,000, the card company will forgive the last $10,000. You jump for joy! The IRS jumps for your wallet.

    The card company will send you an IRS Form 1099-C at the end of the year that reports the $10,000 as income. The IRS says you got $10,000 worth of goods and services with that money, but never paid it back, so it’s income and goes on Line 21 of your tax return.

    The same thing happens if you take out a personal loan for $5,000 and default on it after paying back just $1,000. You had every intention — and obligation — to repay the loan, but things got tight and you can’t pay the other $4,000.

    Once your creditor (or debt collection agency) stops attempting to collect from you, the sum of $4,000 effectively has been given to you. At that point, it is considered income, you will receive a 1099-C form and will be taxed as such.

    Exceptions to Tax Consequences

    There are some exceptions to the taxable income rule, but the largest exception – the Mortgage Forgiveness and Debt Relief Act of 2007 – vanished. Congress could revive it because it was so popular, but as of February 2019, it was not back on the books.

    The Mortgage Forgiveness and Debt Relief Act of 2007 was a temporary act effective through 2017. If your home loan was forgiven for short sales, foreclosures and loan modifications between 2007 and 2017, you did not have to count this as taxable income.

    So, for example, if a borrower wrote off $50,000 in a short-sale, that would not have to be counted as $50,000 worth of income, as it had prior to 2007.

    The act predominantly covers mortgages, but applied to any loan used to buy, build or improve your primary residence. The act allowed the first $2 million of qualifying debt to be excluded from your income. Anything above this was subject to regular income tax. This $2 million cutoff applied to individuals and married couples.

    The original bill was supposed to expire in 2012, but was renewed every year through 2017. The last renewal was slipped into the 2017 budget bill at the last minute, but as of December 2018, there was no word on extending it again.

    Be sure to check on that – and any other late changes made to tax laws – before filing your 2018 returns.

    That still leaves viable exceptions such as:
    • You are insolvent.
    • You file for bankruptcy
    • Some student loan situations
    • The loan is regarded as a gift
    • The debt is qualified farm debt and is canceled by a qualified person
    • The debt is qualified principal residence indebtedness


    The most obvious debt forgiveness exception left for taxpayers is insolvency. You are considered legally insolvent when your total debts exceed your total assets. If you’re insolvent, forgiven debt is excluded from income taxation, but only up to the amount you were insolvent.

    Assume you have $100,000 in assets, including your home, car, retirement accounts, investments and anything else in your name. You also have $120,000 in debt such as your mortgage, auto loans, credit card debt and student loans. You are considered insolvent because your debts exceed your assets, in this case by $20,000.

    Now assume $30,000 of credit card debt is forgiven. This is greater than the amount by which you were insolvent. Only the first $20,000 — the amount of insolvency — is exempt from taxation. The remaining $10,000 of forgiven debt is taxable.

    The IRS refers to debts as “liabilities” and defines them in unfamiliar terms such as
    • Recourse debt, which is debt the borrower is personally liable for, even after the lender has taken the collateral involved such as a home or credit cards.
    • Nonrecourse debt, is debt the borrower is not personally responsible for. It does not allow the lender to pursue anything beyond the collateral used to back the loan.


    No forgiven debt is taxable if it was discharged in any type of bankruptcy. Unlike with home loans and insolvency, there is no limit on forgiven debt in bankruptcy as it relates to taxable income. However, bankruptcy can only cancel debts that exist at the time you file.

    When the Loan Is Deemed a ‘Gift’

    If a family member or friend loans money to you and there is no expectation that you will pay it all back, it can be considered a gift and does not have to be reported as income.

    Student Loan Cancellation

    Canceled student loans are subject to a separate set of taxation rules.

    forgiven student loan is not taxable if it was forgiven under the loan’s provisions. For example, if the loan was forgiven because you went into a specific profession, such as nursing or teaching in underserved areas, the money is not taxable income.

    However, this only applies to loans that have been provided by the government, a tax-exempt public company or a school with programs to benefit underserved areas. It does not apply to private education loans.

    Some student loans are canceled and not considered income if you work them off with certain employers.

    If a student loan was forgiven under other circumstances, such as an inability to pay, then normal income tax regulations apply.

    Form 982 to Waive Tax Liabilities

    As stated above, there are exceptions to the laws governing tax liability for debts forgiven, but taxpayers must inform the IRS of those exceptions by filling out Form 982.

    Form 982 determines the amount of indebtedness that can be excluded from your gross income.

    If you were insolvent (your debts exceed the value of your assets) or had debts discharged in bankruptcy or in connection with a farm you own, account for the amount forgiven on Form 982.

    That information for Form 982 comes from the 1099-C tax form you receive from the lender, who is simply following laws that require them to send the form to anyone who has more than $600 debt forgiven. The lenders are not supposed to take into account the circumstances under which you may be exempt from paying taxes on that as income.

    If you don’t fill out for 982, it will raise a red flag and possible audit from the IRS for not explaining why you didn’t count the forgiven debt as income.

    Reporting the Forgiven Debt

    In order to track your forgiven debt amount, the IRS requires that your creditor issue you a 1099-C form in January for any unpaid debts over $600 that were forgiven during the preceding year. Your creditor also sends a copy of the 1099-C to the IRS, as well as to your state or local tax collection office, if there is an additional income tax levy where you live.

    And even if your creditor neglects to send you a 1099-C, you should still report your forgiven debt as taxable income, as you can never be sure the amount wasn’t reported to the IRS.

    In most cases, the amount of the tax you pay will be substantially less than the amount of the forgiven debt, so while debt settlement won’t relieve you entirely of your obligations, the net result is still favorable.

    Bill Fay

    Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it seven years ago, helping birth into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering college and professional sports, which are the fantasy worlds of finance. His work has been published by the Associated Press, New York Times, Washington Post, Chicago Tribune, Sports Illustrated and Sporting News, among others. His interest in sports has waned some, but his interest in never reaching for his wallet is as passionate as ever. Bill can be reached at

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