Tax Consequences of Debt-Relief Services

    Debt-relief services can be incredibly helpful when used properly. They can help struggling individuals and families reduce their money troubles and get back on track toward financial wellness.

    Forgiven debt, such as a loan reduced through debt settlement, typically has a catch: It counts as income. In many circumstances, a forgiven debt is subject to income taxes just like those taken out of your paycheck.

    There are some exceptions to this rule. For example, when the government acknowledges that you are unable to pay, such as after you declare bankruptcy.

    Forgiven Debt is Taxable

    Consider a scenario in which you borrow $5,000. You do not pay income tax on the $5,000 because it is not income; you have every intention — and obligation — to repay the loan.

    Now assume you repay $1,000 and cannot repay the remaining $4,000. Once your creditor stops attempting to collect from you, the sum of $4,000 effectively has been given to you. At this point, it is considered income and will be taxed as such.

    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.

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    Exceptions to Tax Consequences

    There are some exceptions to the taxable income rule. The main exceptions are the following scenarios:

    The Mortgage Debt Relief Act of 2007 is a temporary act effective through 2012. If your home loan was forgiven for any reason between 2007 and 2012, you typically do not have to count this as taxable income.

    The act predominantly covers mortgages, but applies to any loan used to buy, build or improve your primary residence. If the discharged debt was not used for your primary residence, it is subject to income tax.

    The act allows only the first $2 million of qualifying debt to be excluded from your income. Anything above this is subject to regular income tax. This $2 million cutoff applies to individuals and married couples.

    Although your forgiven debt won’t be taxed, you are still responsible for reporting the debt on your tax return.


    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 in forgiven debt is taxable.


    No forgiven debt is taxable if it was forgiven 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.

    Student Loan Cancellation

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

    A 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.

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

    Bill Fay

    Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at

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