If you owe a debt to someone who cancels or forgives all or some of the debt, you're treated as having received income for income tax purposes, and you may or may not have to pay tax on this income.
A debt includes debt you’re fully liable for like credit card debt and debt that you’re liable for only up to the value of property securing the debt such as a mortgage debt secured by a home in some states. A debt secured by property may be considered canceled because of a foreclosure, a repossession, you voluntarily returned the property to the lender, you abandoned the property, or because of a loan modification.
If a debt was canceled, forgiven, or discharged, you’ll receive an IRS Form 1099-C, Cancellation of Debt, from the lender or the person who forgave the debt.
Determine whether the cancellation of debt is taxable income or if it qualifies for an exception, which means it isn't taxable income.
The amount of canceled debt is included in your taxable income unless one of the following exceptions applies:
This exclusion allows taxpayers to exclude up to $2,000,000 ($1,000,000 if married filing separately) of canceled "qualified principal residence indebtedness".
If a canceled debt isn't taxable income, you may need to complete IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).
If a canceled debt is taxable, it must be reported as other ordinary income on Schedule 1. Canceled debt income is not subject to Self-Employment Tax.