When a creditor forgives $600 or more of debt, they are required to issue a 1099-C — Cancellation of Debt — to both you and the IRS. The IRS treats cancelled debt as taxable income. A $10,000 settlement on a $15,000 debt generates a $5,000 1099-C. Many debtors successfully settle their debts and then face an unexpected tax bill they were never told about.
The Insolvency Exception
Cancelled debt is not taxable income to the extent the debtor was insolvent at the time of cancellation. Insolvency means your total liabilities exceeded your total assets immediately before the cancellation. If you owe $50,000 and your assets total $20,000, you are insolvent by $30,000. Up to $30,000 of cancelled debt is excluded from income. File IRS Form 982 with your tax return to claim the exception.
Bankruptcy Exception
Debts discharged in bankruptcy are excluded from income entirely. There is no dollar limit. If you are considering bankruptcy alongside settlement, the tax treatment of cancelled debt is a factor worth weighing.
Document the Insolvency Calculation
Before settling any significant debt, calculate your insolvency position on the date of settlement. List every liability (credit cards, loans, medical bills, taxes owed) and every asset at fair market value. If liabilities exceed assets, you likely qualify for the insolvency exclusion. Keep the documentation with your tax records.
Educational use only. Not legal advice. Justice Foundation.
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