Cancellation of debt income exclusions are the rules in Section 108 of the Internal Revenue Code that keep forgiven debt off your taxable income. For 2026 there are four working exclusions: debt canceled in a bankruptcy case, debt canceled while you are insolvent, qualified farm debt and qualified real property business debt. The fifth, for a main home mortgage, expired for discharges after December 31, 2025.
Every one of the cancellation of debt income exclusions comes with a cost. You report the excluded amount on Form 982 and, in most cases, reduce tax attributes such as loss carryovers and asset basis. This guide covers the starting rule, each exclusion in the order the law applies them, a worked insolvency calculation, attribute reduction and how Form 1099-C and Form 982 fit together, all based on IRS Publication 4681 and the statute as of October 2026.
The starting point is Section 61. Its list of gross income items includes, at paragraph (11), "[i]ncome from discharge of indebtedness" (26 U.S.C. § 61). When you borrow, the loan proceeds are tax free because you promise to repay them. Once a lender lets you off that promise for less than you owe, the unpaid amount becomes an economic gain, and the default rule taxes it as ordinary income.
IRS Topic 431 puts it plainly: "In general, if your debt is canceled, forgiven, or discharged for less than the amount owed, the amount of the canceled debt is taxable." Common triggers include a credit card settled for less than the balance, a personal loan written off, a mortgage shortfall after a foreclosure or short sale, and a business loan reduced in a workout.
Taxable canceled debt goes on a different line depending on what the debt financed. Publication 4681 lists Schedule 1 (Form 1040), line 8c, for nonbusiness debt, Schedule C, line 6, for a nonfarm sole proprietorship, Schedule E, line 3, for nonfarm rental real estate and Schedule F, line 8, for farm debt. Landlords who need a refresher on that schedule can use our Schedule E guide for rental property owners.
Some forgiven amounts are never income in the first place. Topic 431 lists these exceptions, including amounts canceled as gifts or inheritances, debt that would have been deductible had a cash basis taxpayer paid it, a qualified purchase price reduction from the seller and certain student loan discharges. Exceptions "apply before the exclusion" and "do not require you to reduce your tax attributes," so check them first.
Settling a federal tax bill follows a separate process. An offer in compromise is the IRS program for that, with its own eligibility tests and paperwork.
Section 108(a)(1) excludes canceled debt from gross income when the discharge occurs in a title 11 case, when the taxpayer is insolvent, when the debt is qualified farm indebtedness, when it is qualified real property business indebtedness (for taxpayers other than C corporations) or when it is qualified principal residence indebtedness discharged before January 1, 2026 (26 U.S.C. § 108). The statute also sets an order. Bankruptcy overrides everything else, and insolvency is applied before the farm and real property business exclusions. Where the principal residence exclusion still applies, it takes priority over insolvency unless you elect insolvency instead.
| Exclusion | Form 982 box | Who can use it | Limit | What gets reduced |
|---|---|---|---|---|
| Title 11 bankruptcy | Line 1a | Debtor in a court-supervised case | Full amount discharged | Tax attributes in statutory order |
| Insolvency | Line 1b | Liabilities exceed FMV of assets | Amount of insolvency | Tax attributes in statutory order |
| Qualified farm debt | Line 1c | Farmers meeting the 50% gross receipts test | Adjusted tax attributes plus basis of qualified property | Tax attributes, then qualified property basis |
| Qualified real property business debt | Line 1d | Non-C corporation taxpayers who elect it | Two caps based on FMV and depreciable real property basis | Basis of depreciable real property only |
| Qualified principal residence debt | Line 1e | Main home acquisition debt | $750,000 ($375,000 MFS) | Basis of the main home only |
Publication 4681 states that "[d]ebt canceled in a title 11 bankruptcy case isn't included in your income," and that this covers all chapters, including chapters 7, 11 and 13 (IRS Publication 4681). You must be a debtor under the court's jurisdiction, and the court must grant the discharge or approve the plan that produces it. You check line 1a of Form 982 and enter the full amount discharged on line 2.
You are insolvent "to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation." Assets include everything you own, including collateral and assets creditors cannot reach, such as a pension interest or a retirement account. The exclusion is capped at the amount of insolvency, so any canceled debt above that amount stays taxable. The IRS provides an Insolvency Worksheet in Publication 4681 for the calculation, and you keep it with your records.
Farm debt qualifies when it was incurred directly in operating a farming business, at least 50% of your gross receipts for the three prior tax years came from farming, and the lender is a "qualified person," meaning someone actively and regularly engaged in lending money or a government agency. For a 2026 discharge, that look-back covers 2023, 2024 and 2025. The excluded amount cannot exceed the sum of your adjusted tax attributes and the adjusted basis of qualified business property. Bankruptcy and insolvency apply first.
This exclusion is elective and is unavailable to C corporations. The debt must have been incurred or assumed in connection with real property used in a trade or business, be secured by that property and, if incurred after 1992, be qualified acquisition indebtedness, meaning debt used "to acquire, construct, reconstruct, or substantially improve" the property (26 U.S.C. § 108). Real estate held for sale to customers does not qualify. The exclusion cannot exceed the debt's principal over the property's FMV, and it cannot exceed your adjusted basis in depreciable real property. The excluded amount reduces that basis, which later shows up as ordinary income under the depreciation recapture rules when the property is sold at a gain.
The home mortgage exclusion did not survive into 2026. Publication 4681, prepared for 2025 returns, says under What's New: "Qualified principal residence indebtedness cannot be excluded from income for discharges completed or discharge agreements entered into after December 31, 2025." The One Big Beautiful Bill Act, enacted July 4, 2025, did not extend it, and Topic 431 (last updated September 2026) still limits the exclusion to debt "discharged before January 1, 2026, or discharged subject to an arrangement that is entered into and evidenced in writing before January 1, 2026."
That written-arrangement rule matters for 2026 files. A short sale or loan modification agreed in writing during 2025 can still use the exclusion, up to $750,000 ($375,000 if married filing separately), even if the discharge itself happens in 2026. A homeowner whose shortfall was negotiated in 2026 must look to bankruptcy or insolvency instead. Bills to restore the exclusion have been introduced, but as of October 2026 none has been enacted.
How the shortfall is measured also depends on the loan. Under Topic 431, with recourse debt the amount realized is the property's FMV and the excess of the debt over that value is cancellation income, while with nonrecourse debt the full debt is the amount realized and there is no cancellation income at all. The gain or loss side of that deemed sale is reported through Schedule D and Form 8949 for capital assets.
Maya owes $31,000 on a credit card. In March 2026 the issuer accepts $6,000, payable in installments, and cancels the remaining $25,000. She has no bankruptcy case and no farm or business real estate.
| Immediately before the cancellation | Amount |
|---|---|
| Checking account | $2,500 |
| Car (FMV) | $11,000 |
| 401(k) balance | $28,000 |
| Household goods (FMV) | $4,500 |
| Total assets (FMV) | $46,000 |
| Credit card balance | $31,000 |
| Car loan | $9,000 |
| Student loan | $24,000 |
| Total liabilities | $64,000 |
| Amount of insolvency | $18,000 |
The 401(k) counts as an asset even though creditors cannot reach it, which is the item people most often leave out. Maya was insolvent by $18,000 ($64,000 minus $46,000), so she can exclude $18,000 of the $25,000. The remaining $7,000 is taxable and goes on Schedule 1, line 8c. She checks line 1b of Form 982 and enters $18,000 on line 2.
Attribute reduction follows. Maya carried a $7,000 capital loss into 2026 and has no capital gains, so her 2026 return uses $3,000 of it against ordinary income first. The remaining $4,000 carryover is then reduced to zero. That leaves $14,000 of excluded debt to apply against basis. For nonbusiness debt, the Form 982 instructions limit the line 10a basis reduction to the smallest of her nondepreciable property basis, the excluded nonbusiness debt on line 2, and the excess of her property basis plus cash over her liabilities right after the discharge. Assume her basis in everything she owns plus her cash is $31,500, while her remaining debts are $39,000 ($9,000 car loan, $24,000 student loan and the $6,000 settlement balance). That third limit is zero, so no basis is reduced, and the unused $14,000 simply drops away.
When the bankruptcy or insolvency exclusion applies, Publication 4681 lists the attributes to reduce, in order, after you figure the tax for the year of discharge:
You can elect to reduce the basis of depreciable property first, which preserves NOLs and credits for later use at the price of lower future depreciation. Clients with large carryforwards should review the NOL carryforward rules before choosing, since that election changes which attribute absorbs the cut. Passive carryovers are reduced sixth, so investors with suspended rental losses under the passive activity loss rules can lose them.
Entity type changes where these tests apply. For a partnership, the exclusion and attribute rules apply at the partner level, so a partner's own insolvency controls. For an S corporation, they apply at the corporate level, and an excluded amount does not pass through to shareholders, which affects the stock and debt basis figures on Form 7203.
Form 982 is attached to the return for the year of discharge. Part I identifies the exclusion and the excluded amount, and Part II records the attribute reductions. The IRS Form 982 instructions explain that the line 2 total will not always match the reductions in Part II, because the discharged amount can exceed the attributes available to reduce.
The Instructions for Forms 1099-A and 1099-C require a lender to file Form 1099-C "for each debtor for whom you canceled a debt owed to you of $600 or more" once an identifiable event has occurred. Box 2 shows the amount of debt discharged, box 3 any interest included in that figure, and box 6 the identifiable event code. A lender that cancels debt tied to a foreclosure in the same year can file Form 1099-C alone instead of both forms.
Form 1099-C still uses the $600 threshold in those instructions, while the 2026 1099 reporting threshold rose for Forms 1099-NEC and 1099-MISC. The IRS receives a copy, so a 1099-C that never reaches the return, or reaches it without a Form 982 explaining an exclusion, can trigger an IRS CP2000 notice. Topic 431 also says your duty to report the correct amount stands "regardless of the accuracy of the Form 1099-C you received," and if a creditor keeps trying to collect, the debt may not have been canceled at all.
The American Rescue Plan Act rule that excluded most student loan discharges from 2021 through 2025 ended on December 31, 2025. Discharges in 2026 under programs without their own exclusion, such as forgiveness at the end of an income-driven repayment plan, are generally cancellation of debt income again, and insolvency can still shelter part of it. Discharges because of the student's death or total and permanent disability can still be nontaxable, though Publication 4681 notes that for discharges after 2025 "you will have to include your SSN on your tax return," and the SSN must be valid for employment. Loans canceled for working a set period in certain professions keep their separate exception. State conformity varies, so the state treatment needs its own check.
Which cancellation of debt income exclusions apply in 2026? Bankruptcy, insolvency, qualified farm debt and qualified real property business debt all apply to 2026 discharges. The principal residence exclusion applies only to debt discharged before January 1, 2026, or under a written arrangement entered into before that date.
Do retirement accounts count when testing insolvency? Yes. Publication 4681 says assets include exempt assets beyond the reach of creditors, and it names pension interests and retirement accounts. Leaving them out overstates insolvency.
Do I need Form 982 if the debt was canceled in bankruptcy? Yes. You check line 1a, enter the excluded amount on line 2 and complete Part II to reduce tax attributes, even though none of the discharged debt is taxable.
Is canceled debt taxable if no Form 1099-C arrives? It can be. The duty to report taxable canceled debt depends on the discharge itself, and a lender below the $600 filing threshold may not issue a form.
Madras Accountancy supports US CPA firms and their clients with outsourced tax preparation and bookkeeping support, including canceled debt files where the insolvency worksheet and Form 982 need to be prepared for reviewer sign-off. To discuss a return or a seasonal workload, contact our team.
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