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How Debt Settlement Impacts Your Taxes

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In a Nutshell

When you settle a debt with a creditor, you pay less than what you owe. The remaining amount is forgiven debt — also called canceled debt — which is often counted as taxable income. Debt settlement can make your tax returns more complicated or increase the taxes you owe. This article will discuss debt settlement and how forgiven debt affects your taxes. Understanding the tax implications of canceled debt will help you be better prepared to negotiate debt forgiveness with your creditors. It’ll also help you understand how to prepare your tax returns correctly.

Written by Attorney Eric Hansen
Updated October 5, 2021

You might think that once you’ve successfully negotiated a debt settlement on an outstanding debt that you are done and you can kick up your feet and relax. Not so fast. When you settle a debt with a creditor, you pay less than what you owe. The remaining amount is forgiven debt — also called canceled debt — which is often counted as taxable income. Debt settlement can make your tax returns more complicated or increase the taxes you owe.

This article will discuss debt settlement and how forgiven debt affects your taxes. Understanding the tax implications of canceled debt will help you be better prepared to negotiate debt forgiveness with your creditors. It’ll also help you understand how to prepare your tax returns correctly. 

Factors That Determine Whether Forgiven Debts Are Taxable

When a lender forgives more than $600 of debt, it’s usually taxable. But there are some situations where forgiven debt is not taxable. In cases of insolvency, debts discharged due to bankruptcy, student loan forgiveness, and a few other less common scenarios, forgiven debts are not taxable. 

Insolvency Test

Forgiven debts are not taxable when you are insolvent. Insolvency looks at your liabilities and assets. Liabilities are all your outstanding debts and what you owe to creditors. Assets are what you own like the equity in your home, money in your bank account, retirement funds, and investments. You are insolvent if your total financial liabilities are greater than your total assets. 

It’s not enough to say you are insolvent to avoid paying taxes on forgiven debt. You have to prepare an assets and liabilities chart. This lists the value of your assets and the total amount of debt from your liabilities. If your net worth is negative, then you are insolvent and your forgiven debt should not be taxable. As with most tax-related things, there’s a form for this. If You’ve come to a debt settlement with one of your lenders but you’re insolvent, you’ll need to use IRS Form 982 to show it. Otherwise, the IRS will consider the forgiven debt taxable income.


If you file for Chapter 7 bankruptcy, many of your debts will be discharged. Debts discharged, or wiped away, during bankruptcy are not taxable. People who file Chapter 7 bankruptcy are typically insolvent anyway — meaning their liabilities exceed their assets. If the IRS considered the debt discharged in bankruptcy to be taxable, this could end up creating a tax debt for bankruptcy filers, which defeats the purpose of filing bankruptcy in the first place. 

You can file Chapter 7 bankruptcy on your own or with the help of a bankruptcy attorney. Upsolve is a nonprofit that can help you file your Chapter 7 bankruptcy case for free. Use our free tool to see if you qualify. 

Student Loan Forgiveness

Until recently, student loan forgiveness was taxable. Student borrowers received a 1099-C form indicating how much of their canceled debt was considered gross income. They were then responsible to pay taxes on this “income” on their annual tax returns. This changed in March 2021 when President Biden signed the American Rescue Plan into law. Under this plan, any student loan debt that is forgiven is not taxable. Keep in mind that this may change moving forward as Congress elects new representatives.

There are some special types of student loan forgiveness that aren’t taxable. One example is the Public Service Loan Forgiveness (PSLF) program. Under this program, borrowers who work for certain public interest organizations, nonprofit organizations, or government entities for a defined period can have their student loans forgiven. While time will tell if general student loan forgiveness remains tax-free, it’s unlikely that student loan forgiveness from PSLF or other similar programs would become a tax liability for student borrowers.

Other Situations

There are some other less common situations when a forgiven debt is not taxable. For example,  canceled debt as part of an inheritance is not usually taxable or considered gross income. The IRS provides several FAQs, resources, and guidance about tax issues including any tax implications from debt settlement and whether or not forgiven debts are taxable.

Other canceled debts that may not be taxable include:

  • Loan forgiveness programs that provide health services;

  • Student loans discharged due to the student’s death or permanent disability;

  • Debt canceled on real property that is business-related;

  • Debt settlement related to qualified farm debts; and

  • Forgiven debts from qualified principal residence indebtedness from an agreement before January 1, 2021.

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Taxes After a Home Foreclosure

There are tax implications to consider after a home foreclosure. While a home foreclosure might not feel like debt forgiveness or an amicable debt settlement, debt that’s forgiven or canceled as part of a foreclosure may be taxable. Generally, home foreclosures are treated like a taxable sale of real property on taxpayers’ income tax returns. But in most circumstances, most of the “gain” and sometimes even the entire “gain” from a home foreclosure is not considered taxable income.

You’ll want to report the taxable amount on Schedule D, Capital Gains and Losses on your tax returns if any of the following are true:

  1. The foreclosure is not a personal residence exemption; or

  2. The foreclosure doesn’t qualify from the exclusion mentioned under question number 3 on tax consequences question in this IRS publication; or

  3. The gain exceeds $250,000.

Using Bankruptcy To Stop or Slow Foreclosure

Declaring bankruptcy can be a useful tool to prevent or at least slow down a home foreclosure. Once you file bankruptcy, the court will issue an automatic stay. This protects you from your creditors and any collections activities while the bankruptcy is in process.

There are two types of bankruptcy: Chapter 7 and Chapter 13. The foreclosure process works differently with each. Filing for Chapter 7 bankruptcy can help you deal with unsecured debt like credit card debt and it can buy you some time to make a plan to deal with your other debts. It won’t stop a foreclosure, but it can help postpone it. 

If you file Chapter 13 bankruptcy, you’ll have a payment plan that can help you address your secured debts, like your home. This can stop the foreclosure process. Consulting with a bankruptcy attorney can help you understand your legal rights. If you’re facing foreclosure and tax ramifications, consider getting legal assistance to decide the best path forward for you. Also, can check out Upsolve’s free bankruptcy screener tool to get a better idea of what bankruptcy is and if it’s right for you and your family.

Planning for the Tax Consequences of Debt Settlement

Generally, if your lender is willing to negotiate with you on a debt settlement, you should do it even if there are tax consequences. That’s because the amount you end up paying in taxes will be less than that of the amount of debt your lender forgives. Still, it’s good to be mindful that your tax bill may be higher. Preparing for a higher tax bill is just smart tax planning. You can try to put some money aside to cover the additional tax penalty. 

Or, if possible you can pay these taxes before filing your annual tax return to the IRS. This can help you avoid an underpayment penalty. Most taxpayers either have their employer withhold taxes from their paycheck or make quarterly estimated tax payments to the IRS. But if you have more taxable income in a given year because a lender forgives a debt (and it isn’t subject to an exception or exemption) and you haven’t accounted for it in your withheld taxes or quarterly payments, you may face an underpayment penalty. 

Rather than dealing with an underpayment penalty or having to pay the estimated income tax payments when you file your annual tax returns, you could just make a payment to the IRS on its website or ask your employer to adjust your tax withholdings from your regular paycheck. Some taxpayers routinely adjust their tax withholdings throughout the tax year because their income fluctuates seasonally.

IRS Payment Plans

If you’re unable to pay off your tax bill in one year, don’t panic. The IRS offers payment plans. These options include an installment agreement, a partial payment installment agreement, an offer in compromise, and a currently not collectible status. 

The installment agreement — the IRS’s first choice in payment plan options — usually requires that you pay your tax debt in full within six years. With this agreement, you don’t have to demonstrate hardship or lack of financial ability. The partial payment installment agreement is a little more restrictive than the installment agreement. It requires more financial documentation so the IRS can assess if you can pay your tax debt. Other tax debt relief options with the IRS are more restrictive and have more difficult requirements. A tax professional may be able to provide more insight into tax relief options with the IRS.

Let’s Summarize…

When a lender reduces, settles, forgives, or cancels your debt, that normally counts as taxable income. There are some exceptions though. Canceled debt is usually not taxable for debts forgiven in bankruptcy, with student loan forgiveness, when there’s insolvency, and in other less common circumstances. If you are feeling overwhelmed or confused you should consult with a tax professional, especially if you have a complex or unique situation. Also, you may want to consult the IRS for further clarification on your tax liability or tax consequences from a forgiven debt. 

If you’re considering having your debts forgiven by filing bankruptcy, Upsolve can help you schedule a free consultation with an experienced, independent bankruptcy attorney.

Written By:

Attorney Eric Hansen

Eric D. Hansen is an experienced Minnesota attorney within a number of varying and nuanced practice areas. He has operated his own solo practice as well as worked at small suburban boutique firms and large diversified downtown law firms. Eric has a wealth of experience in busines... read more about Attorney Eric Hansen

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