What To Know About Loan Forgiveness And How It Affects Your Taxes
Do you have loans you're looking to get some relief from? Or maybe you've already had a student loan forgiven and are now wondering how that affects your taxes. You could be feeling overwhelmed with uncertainty, but navigating the tax implications of loan forgiveness doesn't need to be complicated! This post will explain what happens when you report forgiven debt on your income tax return.
What is loan forgiveness and how does it work
Loan forgiveness is when a lender agrees to forgive or cancel all or part of a borrower's remaining debt. There are several different types of loan forgiveness.
Credit card debt settlement
Credit card debt settlement is usually granted at the discretion of the lender. For example, say you faced financial hardship and fell behind on your credit card payments. You may be able to negotiate with your credit card company to have them forgive a portion of the amount you owe in exchange for repaying the remaining amount in a lump sum or over a series of payments.
Student loan forgiveness
Some government programs are available to assist borrowers in paying off their student loans. For example, if you have a federal student loan and work full-time for a U.S. federal, state, local, or tribal government or non-profit organization, you may be eligible to have some of your student loan debt forgiven through the Public Service Loan Forgiveness (PSLF) program.
Mortgage debt forgiveness
In a mortgage modification, the lender agrees to adjust your loan amount to accommodate your current financial situation and avoid foreclosure. This type of loan forgiveness gained popularity during the 2008 housing crisis but is not as common today.
How does loan forgiveness impact your taxes?
If you have any kind of debt forgiven or settled for less than you owe, it's typically considered taxable income—but there are some exceptions, which we'll cover in detail below.
The IRS considers forgiven debt to be taxable income because it is an economic benefit. This means that if your lender agrees to forgive a portion of your loan, the amount forgiven will be treated as income, and you must pay taxes on it. This applies regardless of whether the forgiven debt was due to loan consolidation, loan modification, loan rehabilitation, or some other type of provision.
Exceptions to treating loan forgiveness as taxable income
There are several ways to avoid having your canceled loan treated as taxable income, depending on the type of debt you had canceled and your financial circumstances.
Exceptions for student loan forgiveness
If you have a student loan that has been forgiven as part of any federal student loan forgiveness program, you will generally not be required to pay federal income taxes on the forgiven amount. However, that isn't necessarily true at the state level. Some states have rules permitting taxing the forgiven balance, while some have publicly announced they will not consider forgiven student loan debt taxable income.
Check with your tax professional to determine how student loan forgiveness might impact your state income tax filing.
Exceptions for other types of debts
For other types of debts, the IRS provides several exceptions to cancellation of debt income, including:
- Amounts canceled as gifts, bequests, or inheritances. For example, say you borrow money from your grandmother to start a business and sign a promissory note. Your grandmother passes away, and in her will, she relieves you of the obligation to repay the loan, treating it as a bequest. The debt cancellation isn't taxable.
- Amounts of canceled debt that would be deductible if you paid it. Say you operate a business and use the cash basis of accounting. You charged some business expenses on a credit card, then ran into financial trouble and couldn't pay the balance. Your credit card company agrees to cancel the debt. The cancellation of debt isn't taxable income, but you cannot claim a deduction for those expenses on your tax return.
- Debt canceled in a bankruptcy case. Generally, debts discharged in a Chapter 7, Chapter 11, or Chapter 13 bankruptcy filing aren't taxable.
- Insolvency. You are insolvent if your total debt is more than the fair market value of your assets. For example, say your credit card company cancels your outstanding balance of $7,000. At that time, your only assets are a bank account with a $1,000 balance and a car worth $5,000. You have other debts totaling $10,000. In this case, you owe more than you have, so you qualify for the insolvency exception.
- Qualified principal residence. If you have mortgage debt forgiven on your principal residence as part of a foreclosure, loan modification, short sale, or deed in lieu of foreclosure, the canceled debt isn't taxable income. This exception only applies through December 31, 2025.
How to prepare for tax season if you have loan forgiveness
After you have a debt canceled or forgiven, the creditor may send you Form 1099-C, Cancellation of Debt. This form shows the amount of debt canceled and the date of cancellation.
If you receive a 1099-C, you should report the amount on your tax return, even if an exception applies. You'll report the canceled debt as "other income" on line Z of Schedule 1 or Schedule C if the debt relates to a sole proprietorship.
If you want to claim an exception to having loan forgiveness treated as taxable income, you'll need to file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your tax return.
If the debt cancellation is taxable, the amount of tax you'll owe depends on your tax bracket. For example, if you're in the 22% tax bracket, an additional $1,000 in taxable income will cost you around $220 in additional taxes.
How can Taxfyle help?
Having a loan forgiven may create taxable income, but many exceptions can help you avoid or at least reduce the amount of taxes you'll owe. If you’re not sure whether or not your canceled loan is taxable, don’t worry! Taxfyle can connect you with a Tax Professional who can help make filing your taxes a breeze this year.
With the help of a tax professional, you can be confident that you’re getting the most out of your refund and minimizing your chances of an audit.