Borrowers face tax bill on debt settled for less than full balance

Borrowers who negotiate a debt settlement for less than the full balance may owe taxes on the forgiven amount. The Internal Revenue Service treats canceled debt of $600 or more as taxable income, a rule that can increase a taxpayer's total liability in the year following the settlement.

The tax impact varies based on the specific amount forgiven and the borrower's financial situation. For instance, if a credit card holder settles a $15,000 balance for $6,000, the remaining $9,000 is generally considered canceled debt. That $9,000 is added to the taxpayer's other income for the year, potentially raising the overall tax bill.

A recent survey by Freedom Debt Relief indicates that many consumers are turning to this strategy. The study found that 20% of respondents carrying at least $10,000 in unsecured debt were behind on at least one account. Additionally, 52% of those surveyed viewed debt settlement as a safe way to manage their balances.

Creditors are required to report cancellations of $600 or more to the IRS using Form 1099-C. Borrowers typically receive a copy of this form during the tax filing period after the debt is canceled. If a settlement is completed in 2026, the form generally arrives in early 2027. Taxpayers must report the canceled amount even if they do not receive the form from the creditor.

Certain exclusions may allow borrowers to avoid paying tax on the forgiven debt. The insolvency exclusion applies if total debts exceed the fair market value of assets immediately before the cancellation. For example, if a borrower has $30,000 in debts and $20,000 in assets, they are insolvent by $10,000. If a creditor forgives $8,000, that entire amount may be excluded from taxable income.

Debt discharged through qualifying bankruptcy proceedings may also be excluded from income. Other specific exceptions may apply depending on the borrower's circumstances. Taxpayers claiming an exclusion typically use Form 982 to document the calculation, while ordinary taxable canceled debt is reported on Schedule 1 of Form 1040.

Accurate reporting requires specific documentation. Borrowers should gather the settlement agreement, proof of payment, and any Form 1099-C received. Those claiming insolvency need records showing asset values and outstanding liabilities from the time just before the cancellation. Consulting a tax professional is often recommended, particularly when multiple debts are settled for less than the full balance.