Debt Settlement Taxes: Handling IRS Bills on Forgiven Debt

The Real Question: Is Your “Savings” Actually Income?

When a creditor agrees to cut your debt, they aren’t just being nice-they are writing off a loss and reporting it to the IRS. In the eyes of the government, if you borrowed money and didn’t pay it back, you effectively earned income. This concept is called Cancellation of Debt (COD) Income.

For the 2026 tax year (filing in 2027) and for those handling 2025 returns right now, the rules have shifted. The “automatic” safety nets that protected homeowners and students are largely gone or narrowed. You now need to actively prove why you shouldn’t be taxed, rather than assuming you won’t be.

Common Mistakes to Avoid

The landscape has changed, and old advice is dangerous. Avoid these specific errors that are currently tripping up taxpayers:

• Ignoring Form 1099-C: If a lender forgives $600 or more, they must send you IRS Form 1099-C. A common error is thinking, “I didn’t get a check, so this isn’t income.” If you don’t report the amount in Box 2, the IRS automated underreporter program will flag you for an audit and penalties.
• Confusing “Settlement” with “Payoff”: If you pay $5,000 to settle a $10,000 debt, the remaining $5,000 is taxable. Many people budget for the settlement payment but forget to set aside cash for the tax bill on the forgiven portion.
• Missing the “Written Agreement” Deadline: The Qualified Principal Residence Indebtedness exclusion (for mortgage debt) technically expired on January 1, 2026. However, if you had a binding written agreement to discharge the debt signed before that date, you may still qualify. Many homeowners overlook this “grandfather clause.”

The “Insolvency” Loophole: Your Primary Defense

With the expiration of specific mortgage and student loan exclusions, the Insolvency Exclusion is now your most powerful tool. It applies to any type of debt-credit cards, medical bills, or personal loans.

The Rule: If your total liabilities exceeded your total assets immediately before the debt was canceled, you do not have to pay tax on the forgiven amount (up to the amount of your insolvency).

Your Checklist: Proving Insolvency

To claim this, you must file Form 982. Use this checklist to see if you qualify. You are insolvent if Column B is larger than Column A.

☐ Step 1: Calculate Total Assets (Column A)
Include everything you own, even if you can’t sell it easily.

• Cash and bank accounts
• Real estate value (current market value)
• Cars (Kelley Blue Book value)
• Retirement accounts (401k, IRA)
• Household goods and electronics

☐ Step 2: Calculate Total Liabilities (Column B)
Include everything you owe.

• Mortgage balance
• Car loans
• Student loans
• Credit card balances
• Medical bills
• The debt that is about to be settled

☐ Step 3: Compare
If (Liabilities) > (Assets), the difference is your “Insolvency Amount.” You can exclude forgiven debt from taxes up to this specific number.

Student Loans: The “Tax Bomb” Returns

The American Rescue Plan Act provided a blanket tax exemption for student loan forgiveness, but that provision expired on December 31, 2025. Here is the new reality for 2026:

Tax-Free (Permanent):

• Public Service Loan Forgiveness (PSLF): Remains 100% tax-free federally.
• Death & Disability Discharges: Generally remain tax-free.

Now Taxable (The Change):

• IDR Forgiveness: If your loan balance is wiped out after 20 or 25 years of payments on an Income-Driven Repayment plan in 2026, that amount is now taxable income unless new legislation passes.
• Settlements: Private student loan settlements are fully taxable.

State Tax Warning: Even if the Feds don’t tax you, your state might. Residents of Indiana, Minnesota, Mississippi, North Carolina, and Wisconsin need to be on high alert. These states have historically taxed student loan forgiveness when the federal government did not. Check your local laws on TaxAct or a similar state tax service.

The Trade-offs: Settlement vs. Full Payment

Deciding to settle debt often feels like a relief, but you are trading one problem for another. Understand the sacrifices before you sign.

1. Credit Score vs. Cash Flow

Settlement: You save cash immediately, but your credit report will show “Settled for less than full balance” for 7 years. This is a major derogatory mark that can drop your score by 100+ points.
Full Payment: Costs more now, but preserves your creditworthiness for future mortgages or auto loans.

2. Immediate Savings vs. Future Tax Bill

Settlement: You might save $10,000 on the loan principal today. However, if you are in the 22% tax bracket and not insolvent, you will owe the IRS $2,200 next April. If you don’t save for this, you effectively swap a bank debt for an IRS debt-and the IRS is much harder to ignore.

3. Ease vs. Audit Risk

Settlement: Filing Form 982 to claim insolvency is complex. It increases the complexity of your tax return and requires you to keep detailed records of your assets and valuations in case of an audit. Paying in full requires no special tax forms.

Decision Guide: What Should You Do?

Choose to Settle If:

• You are “Insolvent” (Liabilities > Assets) and can prove it with Form 982.
• Bankruptcy is your only other option (Chapter 7 bankruptcy discharge is never taxable).
• The debt is old and already dragging down your credit score.

Avoid Settlement If:

• You are “Solvent” (Assets > Liabilities) and have significant equity in a home or retirement account. You will likely owe the full tax bill on the forgiven amount.
• You plan to buy a home in the next 2 years. The “Settled” status on your credit report will be a major red flag to mortgage underwriters.

Now that you understand the tax implications, the next step is to run the math on your insolvency. If you are on the borderline, consider consulting a CPA before finalizing any settlement agreement with a creditor. For specific forms, download the latest Form 982 instructions directly from the IRS website.