Got a 1099-C? How to Avoid Paying Taxes on Forgiven Debt

You finally settled your credit card debt or negotiated a short sale on your home. You feel free. Then, in January, a form arrives in the mail: Form 1099-C (Cancellation of Debt). The IRS considers forgiven debt as “Taxable Income.” Suddenly, you owe the government money on money you never saw. Before you panic, check if you qualify for the Insolvency Exception—the CPA’s secret weapon to wipe out this tax bill.

BMT Tax Team BMT Tax Team · 📅 Mar 2026 · ⏱️ 6 min read · DEBT › TAX
Form
1099-C
Reports Forgiven DebtWarn
Solution
Form 982
Excludes IncomeSave
Rule
Insolvency
Debt > AssetsCheck
IRS Tax Forms desktop arrangement: Form 1099-C (Debt Cancellation) next to Insolvency Worksheet and Form 982 (Tax Exclusion)

The Paperwork Shield: The 1099-C says you owe tax. The Insolvency Worksheet proves you were broke. Form 982 tells the IRS, “I’m exempt.” This trio saves you thousands.

Image Source: bestmoneytip.com

1. Why Is Forgiven Debt Taxable?

To the IRS, borrowing money is not income because you have to pay it back. But the moment you don’t have to pay it back, that money becomes a financial benefit—essentially, income.

The Scenario
  • You owed: $20,000
  • You settled for: $10,000
  • Forgiven Amount: $10,000
The Consequence
  • IRS sees: You “earned” $10,000.
  • Tax Bill: At a 22% bracket, you owe $2,200 in taxes.

2. The “Insolvency” Escape Hatch

You do not pay tax on forgiven debt to the extent that you were insolvent immediately before the cancellation.

Insolvency Definition
Total Liabilities > Total Assets

Self-Test Worksheet

Category Example Items Your Value (Estimate)
A. Total Liabilities
(What you owe)		 Mortgage, Car Loans, Student Loans, Credit Cards, Medical Bills (Everything). $150,000
B. Total Assets
(What you own)		 Home Value, Car Value, 401(k), Bank Accounts, Furniture. -$130,000
C. Insolvency Amount
(A minus B)		 How much you are “underwater.” $20,000

The Verdict

In this example, you are insolvent by $20,000. If the bank forgave $10,000, that entire $10,000 is TAX-FREE because it is less than your insolvency amount ($20,000).

3. How to File: Form 982

This does not happen automatically. If you ignore the 1099-C, the IRS computer will send you a bill. You must tell them, “I was insolvent.”

  • Step 1: Download IRS Form 982.
  • Step 2: Check Box 1b (“Discharge of indebtedness to the extent insolvent”).
  • Step 3: Enter the amount of debt forgiven in Line 2.
  • Step 4: Attach it to your Form 1040 tax return.
  • Step 5: Keep your “Insolvency Worksheet” (from Section 2) in your records in case of an audit.

4. Other Ways to Avoid the Tax

Not insolvent? You might still qualify for other exclusions.

Bankruptcy
If the debt was discharged in a Title 11 Bankruptcy case (Chapter 7 or 13), it is never taxable.
Student Loans
Under current law (through 2025), most student loan forgiveness (PSLF, IDR) is federally tax-free.

5. Frequently Asked Questions

What if I own a house?
You must list the Fair Market Value of the house as an asset. However, you also list the Mortgage as a liability. If you are underwater on the house (Mortgage > Value), it actually helps prove insolvency.
I never received a 1099-C. Am I safe?
No. Creditors are required to mail it by Jan 31, but sometimes it gets lost. If you settled debt, assume the IRS knows. Check your IRS Wage & Income Transcript to be sure.