Debt Consolidation

What You Need to Know About Cancellation of Debt (COD) Income

When you borrow money, to potentially consolidate other debts, and agree to pay it back later, you have now accrued a debt. If your debt is somehow forgiven or the amount you owe is reduced along the way, the forgiven amount may be considered “canceled.”

While having debt “canceled” might sound like a dream come true, you shouldn’t celebrate yet. When a loan amount is forgiven, the IRS may see that forgiven amount as income to be taxed. There are exceptions, of course, and we’ll cover a few of those later.

But first, let’s talk about the different forms of canceled debt you might encounter. While this list isn’t all-inclusive, here are some common types of canceled debt:

  • Debt canceled in a bankruptcy or foreclosure
  • Debt canceled during insolvency
  • Student loan forgiveness

Cancellation of Debt: What You Should Know

While the IRS most likely wants their share any time a debt is forgiven, there are numerous exceptions and exclusions to this rule. And since COD is typically misunderstood and overly complex, there are plenty of details you should know before you get out your checkbook.

Want to know how COD works? Read these important details:

Your main home is probably an exception.

If you borrowed money for your primary residence, you may be able to exclude the canceled amount and avoid paying income taxes on it, notes the IRS. This change comes courtesy of the Mortgage Forgiveness Debt Relief Act, which took effect in 2007.

However, it does matter how you used the money.

“You must have used the loan to buy, build or substantially improve your main home to qualify,” writes the IRS on their website. “Your main home must also secure the mortgage.”

If you’re unsure where you stand, use this Interactive Tax Assistant tool on to find out if your canceled mortgage debt is taxable.

Loans that were forgiven as “gifts” aren’t subject to taxation.

If your canceled debt came from a bank or any other type of lender, the chances of having it forgiven as a gift are slim to none. But if your loan was made by a private lender (think family member or friend), getting loan forgiveness as a gift could get you off the hook.

On the flip side, however, the “giver” will need to file a gift tax return if they forgive more than $13,000 (the gift tax annual exclusion) in a single year.

Debts forgiven during bankruptcy or insolvency don’t count towards your income.

If you file for bankruptcy protection, your forgiven debts won’t count as taxable income. The same is true for debts canceled during “insolvency” – a term used to describe the condition where your liabilities exceed your assets.

Different types of student loan forgiveness receive different tax treatment.

Graduates suffering from mounting student loan debt may have several options to choose from when it comes to forgiveness. Whether they’ll pay taxes on forgiven amounts depends on which type of forgiveness they settle on.

With Public Service Loan Forgiveness (PSLF), for example, canceled debts are not considered taxable income. To qualify, students must work ten years in a qualified public service position and make 120 consecutive, on-time payments on their loans.

Income-driven repayment plans like Pay As You Earn (PAYE), Revised Pay As You Earn (REPAYE), and Income-Based Repayment (IBR) are totally different animals. With each of these plans, you pay a specific percentage of your income for 20-25 years before your debts are forgiven. But, not so fast. Once your debts are canceled, forgiven amounts are treated as taxable income.

There are other student loan forgiveness plans to consider as well, so make sure to check whether your canceled debts will be considered income before you sign up.

Cancelled debts come with tax forms.

When a lender forgives a debt, that amount must be accounted for with the IRS. Thus, you should plan on receiving a Form 1099-C for any canceled debts you accrue provided the canceled amount is more than $600.

If your debt is not actually taxable because you qualify for an exclusion, fill out a Form 982 – Reduction of Tax Attributes Due to Discharge of Indebtedness – and file it with your federal income tax return.

Price adjustments aren’t treated as income.

The difference between a price adjustment and forgiven debt may be on paper only, but it can mean the difference between paying taxes on COD income or avoiding them. Let’s say you bought a property for $300,000 and still owed $250,000 on the mortgage, yet the property is now worth only $200,000.

If your lender cancels $50,000 of your loan to get it down to market value, you’ll owe income tax on the forgiven amount. If the loan reduction is noted as a price reduction, however, you won’t pay taxes on the forgiven amount.

When it comes to COD income, exclusions and exemptions are abound.

While the rules regarding some exclusions and exceptions are tricky, the number of ways to avoid paying income on canceled debt are vast. We have covered some of these exclusions already, but here is a full list of the main exclusions and exceptions, as reported by tax preparer, TurboTax:


  • Cancellation of qualified principal residence indebtedness
  • Debt canceled in a Title 11 bankruptcy
  • Debt canceled during insolvency
  • Cancellation of qualified farm or real property indebtedness


  • Certain qualified student loans
  • Money excluded from income by law, such as gifts or bequests
  • Canceled debt that if paid by a cash-basis taxpayer would otherwise be deductible
  • A qualified purchase price reduction given by a seller
  • Any Pay-for-Performance Success Payments that reduce the principal balance of your mortgage under the Home Affordable Modification Program

Final Thoughts

The tax code can be impossible to understand, and issues like Cancellation of Debt (COD) add yet another layer of mystery. If you’re worried about paying income taxes on forgiven debts, the best thing you can do is speak to a qualified tax professional or accountant to find out where you stand.

With some luck and appropriate tax planning, you may be able to avoid being taxed on forgiven debts. If not, you can strive to plan better next time.

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