5 Ways To Avoid Paying Taxes On Cancelled Debt

Posted on: 23 September 2020


Debt relief through the cancellation of a debt owed—when a lender "writes off" the remaining portion of debt for various reasons—can be a big help when you are struggling under a debt burden.

But this action does have tax consequences that often come as a surprise to borrowers. Cancellation of debt is generally taxable income on your annual Form 1040. However, there are important exceptions that don't require you to pay taxes on this income. Here are the five most common exceptions you may qualify for. 

1. Government Forgiveness Programs

If you qualify for a student loan or home mortgage forgiveness arrangement offered by the state or federal government, it includes provisions that this debt would not be taxable income. You would need to follow the program's guidelines to determine if or how to report this as a nontaxable income. 

2. Bankruptcy Discharge

Bankruptcy usually includes the discharge of at least some of a debtor's obligations, and it wouldn't be very valuable if you still had to pay taxes on what is discharged. Fortunately, the bankruptcy process is one of the most common exceptions to the taxable income rule. 

3. Insolvency

Insolvency occurs when a taxpayer's debts outweigh their assets. If you were considered insolvent when your debt was cancelled, you may qualify for an exception regarding the taxable income rules. The IRS has guidelines to determine if you were insolvent as well as what dates you must use to make the calculations. These can be somewhat complex, though, so a tax preparer can help you file for this. 

4. Relief Through an Estate

If you owe money to an individual or their business, they can include the resolution of this in their estate plans. If a person's will or estate planning documents specify that you no longer owe the debt upon their passing, it is not taxable income. 

5. Certain Business Loans

Business debts often have slightly different rules than personal loans. A sole proprietor or closely-held business owner who uses Schedule C generally can deduct business loan payments and expenses related to them. If you do this, the cancellation of future business debt may not be taxable income. It will simply no longer be a deductible expense. 

Do you believe you qualify for any of these exceptions? If so, you'll first need to determine how to report them properly on your taxes so you avoid any IRS issues or confusion. A tax preparation service can help. Make an appointment today to discuss the specifics of your current or future debt cancellation options.