"Canceled debt income" often referred to as canceled or forgiven debt is something anyone who has debts unpaid, but not gifted, should be concerned with.  The IRS considers this income.

Think of it this way; If your credit card company or lender gave you a loan but you never paid it back then that is definitely income. The money was received by you.

If your debt has been written off by a creditor then you may receive the 1099-c form. You must claim this amount as income on your taxes because you never paid it back thus making it taxable income where the IRS is concerned.

If you settle a debt as "paid in full" with the creditor make sure you ask that they agree to the settled in full arrangement and not send the remainder as a loss to the IRS.

If the creditor willingly accepts "less than" as full payment then make sure they agree not to report remainder -- get it in writing if possible. The creditor can refuse but usually does not when used properly in debt negotiations. See exceptions below for more information on excluded debts. 

Generally, if a debt you owe is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income. You have no income from the canceled debt if it is intended as a gift to you. 

A debt includes any indebtedness for which you are liable or which attaches to property you hold. If the debt is a nonbusiness debt, report the canceled amount on line 21 of Form 1040. If it is a business debt, report the amount on Schedule C or Schedule C-EZ (Form 1040) (or on Schedule F, Profit or Loss From Farming (Form 1040), if you are a farmer). 

Interest included in canceled debt

If any interest is forgiven and included in the amount of canceled debt in box 2, the amount of interest will also be shown in box 3. Whether or not you must include the interest portion of the canceled debt in your income depends on whether the interest would be deductible if you paid it.

If the interest would not be deductible (such as interest on a personal loan), include in your income the amount from box 2 of Form 1099-C. If the interest would be deductible (such as on a business loan), include in your income the net amount of the canceled debt (the amount shown in box 2 less the interest amount shown in box 3). 

Discounted mortgage loan

If your financial institution offers a discount for the early payment of your mortgage loan, the amount of the discount is canceled debt. You must include the canceled amount in your income. 

1099-C Exceptions

There are several exceptions to the inclusion of canceled debt in income. These are explained next. 

Non recourse debt

If you are not personally liable for the debt (non recourse debt), different rules apply. You may have a gain or loss if a non recourse debt is canceled or forgiven in conjunction with the foreclosure or repossession of property to which the debt attaches. See IRS Publication 544 for more information. 

Student loans

Certain student loans contain a provision that all or part of the debt incurred to attend the qualified educational institution will be canceled if you work for a certain period of time in certain professions for any of a broad class of employers.

You do not have income if your student loan is canceled after you agreed to this provision and then performed the services required. To qualify, the loan must have been made by: 

The federal government, a state or local government, or an instrumentality, agency, or subdivision thereof, A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law, or an educational institution:

Under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or as part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization. Section 501(c)(3) organizations are defined in Publication 525. 

A loan to refinance a qualified student loan will also qualify if it was made by an educational institution or a tax-exempt 501(a) organization under its program designed as described in (3)(b) above. 

Deductible debt

You do not have income from the cancellation of a debt if your payment of the debt would be deductible. This exception applies only if you use the cash method of accounting. For more information, see chapter 5 of Publication 334, Tax Guide for Small Business. 

Price reduced after purchase

Generally, if the seller reduces the amount of debt you owe for property you purchased, you do not have income from the reduction. The reduction of the debt is treated as a purchase price adjustment and reduces your basis in the property. 

Excluded debt: Do not include a canceled debt in your gross income in the following situations. 

The debt is canceled in a bankruptcy case under title 11 of the U.S. Code. See Publication 908, Bankruptcy Tax Guide. 

The debt is canceled when you are insolvent. However, you cannot exclude any amount of canceled debt that is more than the amount by which you are insolvent. See Publication 908. 

The debt is qualified farm debt and is canceled by a qualified person. See chapter 4 of Publication 225, Farmer's Tax Guide. 

The debt is qualified real property business debt. See chapter 5 of Publication 334.  Download the 1099C form from the IRS (PDF)

Video below explaining the 1099-C canceled or forgiven debt IRS rule. Form 1099-C. If a federal government agency, financial institution, or credit union cancels or forgives a debt you owe of $600 or more, you will receive a Form 1099-C, Cancellation of Debt. The amount of the canceled debt is shown in box 2 of the IRS form.