How Does Canceled Debt Affect Your Income Tax Liability?

Canceled debt may seem to have nothing to do with your tax liability, but under many circumstances, you could be taxed on the amount of your canceled debt. If a creditor cancels any of your debt, the creditor generally will send you a tax information form that you must include when you file your taxes. There are certain situations in which you can avoid paying tax on your canceled debt.

Canceled Debt

Generally speaking, if you owe any creditor a debt, it usually is due to some benefit you have received. For example, if you have an outstanding credit card debt, you have received money from the credit card company for your own use. If you owe a merchant a debt, you probably have received some type of product in exchange for your promise to pay. If you don't pay back what you owe, the IRS considers the debt cancellation taxable income, since you essentially received either cash or property for free. Unless you qualify for an exception, you must pay tax on that canceled debt.

Reporting on Taxes

If you are the beneficiary of a canceled debt worth at least $600, the creditor canceling the debt must send you a Form 1099-C at the end of the year. The 1099-C lists the date and amount of your canceled debt, along with information on both the creditor and debtor, such as name and address. You are responsible for transferring the amount of your canceled debt on Form 1099-C to your Form 1040 when you file your taxes.

Bankruptcy

Although negotiating a debt settlement with your creditor may in some ways be preferable to filing bankruptcy, bankruptcy has the edge when it comes it taxation. The IRS regards debts canceled in bankruptcy to be nontaxable, so you do not have to include discharged debts on your tax return. If your creditor does send you a 1099-C, the creditor should check the box marked "bankruptcy" to indicate that the canceled debt is not taxable.

Insolvency

If you are insolvent, you do not have assets that exceed the amount of your debts. Although you may be able to declare bankruptcy if you are insolvent, you also can avoid taxation on your canceled debt just by demonstrating insolvency. If you claim insolvency to avoid canceled debt taxation, you must file Form 982 with the IRS.