Because of the coronavirus, millions of Americans are struggling to pay their bills. Some may be seeking debt settlement or loan modification programs that change the terms of their repayment plans.

Unfortunately, if lenders forgive any portion of your debt, you could face a very unpleasant surprise: You may owe taxes on the forgiven amount. 

1040 form with pen and calculator sitting on it.

Image source: Getty Images.

A big tax bill could follow debt forgiveness

As the IRS explains, when you are legally obligated to repay money to a creditor, you have a debt in the eyes of the law. Under certain circumstances, however, lenders may cancel your debt. This can happen if:

  • The debt is forgiven.
  • The lender accepts less than full payment for the debt and discharges the remainder of the debt (classifies it as paid in full and stops trying to collect).
  • The creditor gives up on collecting.
  • Your mortgage is modified.

Cancellation of debt is a taxable event unless you fall within a limited exception: The debt is canceled because of a gift or inheritance, you qualify for specific types of student loan cancellation, the debt would be deductible if it was paid, the debt reduction is a purchase-price reduction a property seller provides to a buyer, or the debt was a student loan discharged due to death or permanent total disability. Another exception is when your home mortgage was reduced under the Home Affordable Modification Program (HAMP). 

When your debt is canceled and you no longer owe money you were previously obligated to pay, you'll receive a 1099-C form from your lender showing both the date your debt was canceled and the amount of debt that you no longer owe. You must report any canceled debts on your 1040 forms and will be taxed at your ordinary income tax rate on the forgiven amount. 

This can be a huge burden for those already facing serious financial struggles that necessitated the debt cancellation in the first place. That is especially true if you have a substantial amount of debt forgiven since it could potentially result in a change in your tax bracket or the loss of eligibility for certain means-tested deductions that are subject to income limits. 

The IRS has taken action to change the rules in the past and ensure canceled debt does not count as income you're taxed on -- for example, when it allowed struggling homeowners to avoid tax if part of their debt was forgiven under HAMP. With COVID-19 causing an unprecedented economic crisis as well as a recession, it's possible the agency could do the same for debts forgiven during the pandemic.

But there has been no sign yet that this has occurred or will occur, so anyone who has any debt forgiven needs to begin preparing now to pay taxes due on the discharged amount. Otherwise, you could be subject to a nasty surprise come tax day when your bill to the IRS is much higher and you can't pay what you owe.