How to avoid tax liability on Arizona debt forgiveness.

One of the ways to deal with excessive debt is to negotiate a debt forgiveness or debt reduction agreement.  However, most people are surprised to learn that the IRS can impose a tax on the amount forgiven or reduced.  This article discusses the federal tax consequences of debt forgiveness and the options to deal with it.

What is Form 1099-C?

Form 1099-C is an IRS form that is used to report “cancellation of debt,” or debt forgiveness.  It is filled out by the lender or creditor and submitted to the IRS.  It identifies the individual who received the debt forgiveness and reports of amount of the forgiven debt.  A copy should be provided to the person identified on the form.

In what situations will Form 1099-C be issued?

Form 1099-C can be issued when a debt you owe is reduced or forgiven.  This includes credit card debt, personal loans, and other types of unsecured debt.  In addition, if you own property subject to a debt, cancellation of the debt may happen because of a foreclosure, a repossession, a voluntary transfer of the property to the lender, abandonment of the property, or a mortgage modification. 

It is important to understand that cancellation of debt may occur not only when you sign an agreement, but also if you owe money and the creditor simply can’t collect, or gives up on collecting.  This type of debt forgiveness is more difficult to plan for, because you do not know when the creditor will decide to give up collecting a debt you owe and issue a 1099-C.

There are some limitations on when a 1099-C must be issued.  First, the amount forgiven must be $600 or more.  Second, issuance of a 1099-C is only required from financial institutions, credit unions, government agencies, and organizations whose significant business is the lending of money.  Other types of creditors are permitted, but not required, to issue a 1099-C.  There are also some costs to the creditor in issuing these forms.  Therefore, it should not be common for 1099-C forms to be issued for small amounts or by creditors that are not banks, credit unions, professional lenders, or a government agency.

What is the significance of receiving Form 1099-C?

The amount reported on Form 1099-C is treated as income by the IRS, and you will have to pay taxes on this income, unless one of the exceptions (discussed below) applies.

Why do I get taxed on money I can’t pay?

Having to pay taxes on money you couldn’t afford to pay in the first place seems unfair, and in a way it is.  The IRS, however, considers cancelled debt to be income, because you received a payment that you do not have to return.  In other words, if you borrowed $1,000 on a credit card, and the credit card company forgave that debt and you do not have to pay it back, it is the same as the credit card company paying you $1,000.  Because this is additional income to you, the IRS considers it taxable.  However, there are ways to protect yourself from this tax liability.

How can I avoid paying taxes on forgiven debt?

There are several ways to avoid being taxed on forgiven debt.  Some of them have to do with the type of debt at issue, and others look at the circumstances of the debt forgiveness.  The main ones are listed below.

Insolvency.  If you were insolvent immediately before the debt was forgiven, the debt forgiveness will not be considered income.  “Insolvent” means that the total amount of your debts was greater than the total value of your assets.

Bankruptcy.  Any debt forgiven in bankruptcy does not constitute income and will not be taxed.  This is one of the major benefits offered by bankruptcy protection.  However, it is important to note that if a debt is forgiven or cancelled before bankruptcy, then filing for bankruptcy later may not eliminate the tax liability, because tax debts are generally much more difficult to eliminate in bankruptcy.  Determining the point at which a debt is forgiven or cancelled can get very complex and will often depend on the specific facts of the situation.  Because of this, if there is a concern that debt forgiveness will give rise to tax liability, it is best to determine early on if bankruptcy should be filed, and to file for bankruptcy well in advance of any debt forgiveness outside of bankruptcy.  

Student Loan Discharge and Forgiveness.  Certain types of federal student loan forgiveness are not taxable, such as forgiveness through government programs that encourage work in certain professions (e.g. Public Service Loan Forgiveness).  Most other types of federal  student loan forgiveness, for example under any income-dependent repayment plan (IDR), is normally taxable.  However, under the American Rescue Plan Act of 2021, any student loans discharged or forgiven between January 1, 2021, and December 31, 2025, are not taxable.  Importantly, this law applies to both federal and private student loans.  For more information in student loan payment and discharge options, read our Ultimate Guide to Eliminating Student Loans.

Qualified Principal Residence Forgiveness.  The federal tax law excludes from your taxable income up to $750,000 in forgiven mortgage debt that you took out to buy or improve your main home.  The discharge or forgiveness must occur prior to January 1, 2026, or you must sign a loan modification or debt forgiveness agreement prior to this date.   In addition, there is not tax liability on “non-recourse” mortgages, meaning a mortgage on which the borrower has no personal liability.  Most purchase-money mortgages in Arizona fall into this category.

Other exceptions.  There are several other exceptions or exclusions that are not as generally applicable.  These include qualified farm indebtedness and qualified real property business indebtedness.  If you have cancelled debt that may fall into any of these categories, it is best to consult with an attorney or an accountant to determine if you will have to pay taxes.


There are several options to avoid federal taxes on settled or forgiven debt: show that you are insolvent, file for bankruptcy before the settlement, or qualify for another exception. Even if there is no federal tax liability, there may still be state tax liability.  Before entering into a debt settlement, it is best to consult an attorney.

If you are in Tucson or Mesa and have questions about your specific debt situation, you can contact Arizona debt forgiveness attorneys at Yusufov Law Firm to discuss the best way to avoid tax liability on debt forgiveness.

The above is provided for general informational purposes only. It is not intended to and does not constitute legal advice, and does not create an attorney-client relationship. If you need legal advice for your specific situation, you should contact a qualified attorney in your area.