If your creditors believe they can’t collect a debt from you, they might waive the payments and send you a Form 1099-C, Cancellation of Debt. The Internal Revenue Service considers this money as income. When you file your annual federal tax return, you need to declare this income and pay the applicable taxes.

Reporting Canceled Debts

When lenders stop trying to collect and forgive debts of $600 or more, excluding any interest or fees, they must send you and the IRS a Form 1099-C. Even if you don’t receive the form, you need to report the forgiven debt on your federal tax return. If you paid back some of the debt, you need to pay taxes only on the amount waived and not the whole debt. Typically, you’ll have to report only one Form 1099-C per tax return. If, however, you receive more than one form from different creditors -- as would happen in a foreclosure -- you might need to contact a tax expert to file your return.

Benefits and Penalties

By sending the Form 1099-C to the IRS, lenders can claim a deduction on their own returns as bad debt and lost income. If you don’t report a received Form 1099-C, you can incur IRS penalties and interest, or the IRS might choose to audit you. You can report a missed 1099-C receipt even after you filed your return with a Form 1040X, Amended U.S. Individual Tax Return. You’ll pay a 0.5 percent late fee for each month the tax remains unpaid. The maximum penalty is 25 percent.

Where to Report

If the income you receive comes from sources such as salaries, tips, taxable interest up to $1,500, unemployment benefits and Alaska Permanent Fund dividends, you can file Form 1040EZ. If you need to include canceled debt income, you can’t file Form 1040EZ. Instead, you’ll need to file Form 1040. For example, if a credit card company cancels your debt, enter the amount as “Other Income” on line 21 of Form 1040. Use Schedule F, line 8, to declare an agricultural debt if you’re a farmer. Or, use Schedule E, line 3, if you incurred the debt while renting nonagricultural property.

Bankruptcy and Insolvency

If you declare bankruptcy, your creditors might waive your debts. They also might write off your debt if they find you're insolvent. In both cases, you don’t need to pay taxes on these forgiven amounts. You’re insolvent if the value of what you own is less than how much you owe. So, if you own $25,000 and owe $35,000, you’re insolvent. Whether or not you pay taxes on the forgiven debt depends on the difference between the value of your assets and debt.

Exceptions to the Rules

You don't need to claim all canceled debts as income. For example, if you took out a nonbusiness loan to take care of damages from Hurricane Katrina, you don’t need to pay taxes on the forgiven loan. Also, if a loan would have been deductible if you had paid it, you don’t need to pay tax on it now that it’s canceled. For example, up to $2,500 of student loan interest is tax deductible. If your lender waives a debt and treats the loan amount as a gift, it is tax free for you, but in 2013, the amount over $14,000 might have been taxable for the lender.