If your debt has been written off by a creditor then you may receive a 1099-C form from the source. You must claim this amount as income on your taxes because you never paid it back- thus making it income.  However if you "settle" this 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.  The creditor can refuse but usually does not. 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 non-business 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).

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.

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.  See Deductible debt, under Exceptions, later.  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.

Stockholder debt

If you are a stockholder in a corporation and the corporation cancels or forgives your debt to it, the canceled debt is dividend income to you.

If you are a stockholder in a corporation and you cancel a debt owed to you by the corporation, you generally do not realize income.  This is because the canceled debt is considered as a contribution to the capital of the corporation equal to the amount of debt principal that you canceled.

Exceptions

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

Nonrecourse debt

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

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.
• 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.
• The debt is qualified farm debt and is canceled by a qualified person.
• The debt is qualified real property business debt.