How to Avoid Paying Taxes on Debt Settlement

Debt settlement is a process for negotiating with your creditors to settle your outstanding debts for less than you owe. While that can save you money, it also has tax implications you should know about before you proceed. Certain types of debt are not subject to taxation, however, such as debt that is canceled due to a gift, bequest, or inheritance, certain types of student loan forgiveness, and debt discharged through Chapter 7, 11, and 13 bankruptcy.

Understanding Taxable Canceled Debt

When a creditor allows you to pay off an account for less than you owe, the amount you didn’t have to pay is referred to as canceled debt. For example, if you owe $10,000 and the creditor agrees to accept $6,000 as payment in full, you have $4,000 in canceled debt. In many cases, that canceled debt is considered taxable income. 

If the amount of the canceled debt is $600 or more, the creditor should send you a Form 1099-C, Cancellation of Debt before you file your taxes for the year. The information on this form is also reported to the Internal Revenue Service. The law requires that you report all taxable canceled debt as income on your tax return, even if the amount is less than $600 and you didn’t receive a Form 1099-C. 

Canceled debt is taxed at same rate as your ordinary income, which can be anywhere from 10% to 37% depending on your total taxable income. For example, if your tax rate is 22% and your canceled debt is $5,000, you would owe $1,100 ($5,000 x 0.22) on the canceled debt.

Exemptions and Exclusions for Debt Settlement

Not all canceled debt is taxable, however, because the law allows for certain exceptions and exclusions. In effect, exceptions are canceled debts that aren’t considered canceled for tax purposes, while exclusions are considered canceled debts but not subject to taxation. Either way you don’t have to pay tax on them.

Exceptions to Taxable Canceled Debt

• Debt that is canceled as a gift, bequest, or inheritance 
• Student loan debt canceled as the result of employment for a required length of time in a certain profession or for a particular type of employer
• Certain student loans discharged between Dec. 31, 2020, and Jan. 1, 2026
• Student loans forgiven through certain student loan repayment assistance programs 
• Canceled debt that would normally be deductible if you had paid it as a cash basis taxpayer 
• Any qualified purchase price reduction provided by the seller of a property 

Exclusions of Canceled Debt From Gross Income 

• All debt canceled under Title 11 bankruptcy. (Title 11 includes Chapter 7, Chapter 11, and Chapter 13 bankruptcies, among other types.)
• Debt canceled due to insolvency
• Qualified farm indebtedness 
• Qualified real property business indebtedness
• Qualified principal residence indebtedness discharged before Jan. 1, 2026

Strategies to Minimize Tax Liability on Debt Settlement

As noted above, proving yourself to be insolvent or filing for bankruptcy are two strategies that can minimize your tax liability from a debt settlement.

Insolvency

Insolvency is when your debt exceeds your assets, leaving you with no way to pay your debts. However, there is a limit to this exclusion: Only the amount by which you are insolvent is excluded.

For example, say you have $80,000 in assets and $90,000 in debts. Because you owe $10,000 more than you have in assets, you are insolvent to the extent of $10,000. 

If you arrange for debt settlement on your credit card debt and $15,000 is forgiven, only $10,000 is excluded because that’s the extent to which you are insolvent. The balance of $5,000 is considered taxable income. 

Bankruptcy

Debt discharged through Title 11 bankruptcy is not taxable. Title 11 shouldn’t be confused with the well-known form of bankruptcy known as Chapter 11. The latter is one of several types of bankruptcy that are included in Title 11. Most individuals file either Chapter 7 or Chapter 13 bankruptcy, while Chapter 11 is primarily for companies.

Reporting Debt Settlement on Tax Returns

All taxable canceled debt must be reported on your annual federal income tax return. To do so, follow these steps.

1. Add up the amounts on any Form 1099-Cs you received from your creditors. Note that it is your responsibility to keep track of and report all of your taxable canceled debt even if you didn’t receive a 1099-C.
2. Enter the total amount of taxable canceled debt on line 8c of the Schedule 1: Adjustments to Income and Additional Income form. 
3. Enter your total Schedule 1 income on line 8 of Form 1040 on your federal tax return. 

Seeking Professional Tax Advice

Determining what is and is not taxable canceled debt can be confusing. So it’s often a smart idea to seek professional tax advice. A good starting point would be to speak with a certified credit counselor. You can find one through such organizations as the Financial Counseling Association of America and the National Foundation for Credit Counseling. 

Talking with a knowledgeable accountant or tax attorney could also be helpful, although more expensive.

The Bottom Line

Debt settlement can provide a lifeline for individuals looking for a way out of crushing debt. However, they may face a significant tax bill if their canceled debt is taxable. Anyone in that situation who can’t come up with the money to pay the tax should contact the IRS and ask about an installment payment plan or other options. However, some types of debt are not taxable so it pays to know the difference.