Accounting for Debt Forgiveness: COD Income, §108 Exclusions, and 1099-C

Cancellation of debt income is the taxable gross income you generally have to report when a lender forgives all or part of what you owe. Under IRC §61(a)(11), a discharged debt is treated as income in the year it’s canceled, and the creditor reports it to the IRS on Form 1099-C if the forgiven amount is $600 or more.¹² Several statutory exclusions can shield some or all of that income from tax, but most of them come with a price: a mandatory reduction of tax attributes like net operating losses and credit carryovers.

When Forgiven Debt Counts as Income

The default rule is simple. If a creditor writes off what you owe, the forgiven balance is ordinary income in the year of cancellation. Receiving a 1099-C doesn’t automatically settle the question of tax, but it does put the IRS on notice, and the agency’s automated matching will flag any return that leaves the reported amount off.

Cancellation can happen in obvious ways (a settlement letter, a bankruptcy discharge) and less obvious ones. A creditor can trigger a 1099-C based on an “identifiable event” such as the statute of limitations expiring, even while the collection file is still open. That distinction matters when you go to challenge the form.

Exclusions Under IRC §108

IRC §108 provides the main paths to exclude cancellation of debt income from gross income.³ Each has its own qualifying conditions. To claim any of them, file Form 982 with your return.⁴

Bankruptcy

Debt discharged in a Title 11 case (Chapter 7, 11, or 13) is excluded in full, with no dollar cap and no regard to your assets. The bankruptcy exclusion takes priority over the others: if the discharge happens in a Title 11 case, you use this exclusion and not any of the alternatives.⁵

Insolvency

Outside bankruptcy, you can exclude cancellation of debt income to the extent you were insolvent immediately before the cancellation. Insolvent means your total liabilities exceeded the fair market value of your total assets. The exclusion is capped at the amount of that shortfall.

If you were insolvent by $30,000 when a $50,000 debt was forgiven, $30,000 is excluded and the remaining $20,000 is taxable.³

Two points on the calculation catch people out. First, assets include everything you own, even the ones creditors can’t reach, such as pension and retirement accounts. Second, nonrecourse debt counts as a liability only up to the fair market value of the property securing it. Publication 4681 includes a worksheet for the calculation and is worth working through line by line.⁵

Qualified Real Property Business and Farm Debt

The qualified real property business indebtedness (QRPBI) exclusion covers debt secured by real property used in a trade or business. It’s available to taxpayers other than C corporations, and the excluded amount can’t exceed the basis of your depreciable real property. A parallel exclusion exists for qualified farm indebtedness. Both are aimed at solvent taxpayers outside bankruptcy, filling the space the insolvency and Title 11 exclusions don’t reach.³

Qualified Principal Residence Debt — Expired

The exclusion for mortgage debt forgiven on a primary residence expired on December 31, 2025. Mortgage debt forgiven in 2026 or later no longer qualifies unless a written discharge arrangement was entered into before January 1, 2026. Homeowners going through foreclosure or a short sale in 2026 have to rely on the insolvency or bankruptcy exclusions instead, if they qualify.⁵

A foreclosure or abandonment can produce two tax events at once: a disposition of the property, which may generate a capital gain or loss, and cancellation of debt income on the balance the lender writes off. Lenders can report both on a single Form 1099-C rather than filing a separate 1099-A.⁶

Student Loan Forgiveness in 2026

The American Rescue Plan Act’s blanket federal tax exclusion for student loan forgiveness applied to discharges between December 31, 2020, and January 1, 2026. It has expired.⁷

Starting in 2026, balances forgiven under income-driven repayment plans are taxable cancellation of debt income. If your remaining balance is discharged after 20 or 25 years of IDR payments, expect a 1099-C for the forgiven amount. Several categories stay permanently tax-free at the federal level:

Public Service Loan Forgiveness
Teacher Loan Forgiveness
Discharges due to death or total and permanent disability

The disability discharge exclusion was recently made permanent at the federal level, though some states may still tax it. Borrowers facing a large IDR forgiveness tax bill should look hard at the insolvency exclusion. Many borrowers whose loans are forgiven after decades of payments have liabilities that exceed their assets, which allows partial or full exclusion through Form 982.⁷

The Trade-Off: Reducing Tax Attributes

Excluding cancellation of debt income under the bankruptcy or insolvency rules isn’t free. In exchange, you have to reduce tax attributes that would otherwise cut future tax bills. The point is to defer the tax, not erase it. IRC §108(b) sets the order:³

Net operating losses for the year of discharge and any NOL carryovers, dollar for dollar
General business credits, at 33⅓ cents per dollar of excluded income
Minimum tax credit, at 33⅓ cents per dollar
Capital losses and carryovers, dollar for dollar
Basis of property (depreciable property first, then other), dollar for dollar
Passive activity loss and credit carryovers, dollar for dollar
Foreign tax credit carryovers, at 33⅓ cents per dollar

You can elect to reduce the basis of depreciable property before working through this order, which sometimes produces a better outcome, particularly when NOL carryovers are more valuable than the depreciation deductions you’d lose. The entire mechanics run through Form 982.⁸

The QRPBI exclusion works differently. Instead of the sequenced attribute reduction, you reduce only the basis of the depreciable real property that secured the debt. Farm debt exclusion has its own reduction rules.

Situations That Look Like COD But Aren’t

Shareholder–Corporation Forgiveness

Debt forgiven between a corporation and its shareholder is recharacterized rather than treated as ordinary cancellation. If a shareholder forgives a corporation’s debt, it’s generally treated as a capital contribution: paid-in capital goes up, and the shareholder’s stock basis increases by the forgiven amount. Going the other direction, if a corporation forgives a shareholder’s debt, the IRS generally treats it as a dividend to the extent of the corporation’s earnings and profits. Business owners can’t wipe out personal debts to their companies without a tax consequence.

Debt-for-Equity Swaps

When a creditor accepts stock to settle a debt, IRC §108(e)(8) treats the corporation as having paid the creditor an amount equal to the fair market value of the stock issued. Cancellation of debt income is recognized only to the extent the debt exceeds that fair market value. Issue $120,000 worth of stock to settle a $150,000 debt, and the corporation reports $30,000 of COD income.³

Purchase Price Reductions

When a seller reduces the debt a buyer owes from the original purchase of property, IRC §108(e)(5) treats the reduction as a purchase price adjustment rather than cancellation of debt income. The buyer reduces the basis of the property, which lowers future depreciation and increases the potential gain on a later sale. This exception doesn’t apply if the buyer is in bankruptcy or insolvent at the time of the reduction.³

If Your 1099-C Is Wrong

A 1099-C in the mail doesn’t necessarily mean the debt was actually canceled. Creditors sometimes file the form prematurely, report the wrong amount, or trigger it on an identifiable event while still attempting to collect. If the form looks wrong, work through these steps.⁹

Contact the creditor first. Confirm whether the debt was actually canceled and, if the amount is wrong, request a corrected form. If the creditor refuses to correct it, report the amount shown on the 1099-C on your return and include an explanation of why the figure is wrong. Don’t just leave the income off; the IRS matching system will flag the mismatch either way, and reporting with an explanation is a much better posture than silence.

If collection activity is ongoing, the cancellation may not have occurred at all. Keep written records of any collection contact as evidence.

Penalties for Leaving It Off

Ignoring a 1099-C is one of the faster ways to draw an inquiry. The IRS receives a copy of every form filed, and its automated matching flags returns where reported income falls short of the information returns on file.

If you omit cancellation of debt income and have no reasonable basis for excluding it, two costs stack up:

An accuracy-related penalty equal to 20% of the underpaid tax. Omitting income shown on an information return is specifically identified as negligence under the penalty rules.¹⁰
Interest on the underpayment at the federal short-term rate plus 3 percentage points, compounded daily. For the first quarter of 2026, the rate for individuals is 7% per year.¹¹

Even if you’re confident an exclusion applies, the safer approach is to report the cancellation of debt income on your return and claim the exclusion on Form 982. The matching system sees the income, your basis for excluding it is on the record, and the penalty exposure disappears.

1
Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined
2
Internal Revenue Service. About Form 1099-C, Cancellation of Debt
3
Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
4
Internal Revenue Service. About Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness
5
Internal Revenue Service. Publication 4681 – Canceled Debts, Foreclosures, Repossessions, and Abandonments
6
Internal Revenue Service. Instructions for Forms 1099-A and 1099-C
7
Taxpayer Advocate Service. What to Know About Student Loan Forgiveness and Your Taxes
8
Internal Revenue Service. Instructions for Form 982
9
Taxpayer Advocate Service. I Have a Cancellation of Debt or Form 1099-C
10
Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
11
Internal Revenue Service. Interest Rates Remain the Same for the First Quarter of 2026