Cancellation of Debt: How It Works and What To Know

Key takeaways

• Debt cancellation is when your creditor wipes away some or all of what you owe.
• Once a debt is cancelled, creditors can’t seek it from you for it later.
• Debt cancellation usually only happens after you’re late on repayment.
• Canceled debts usually count as taxable income.

Cancellation of debt means your lender has agreed that you no longer have to repay what you owe. It could be through a debt settlement, bankruptcy or student loan forgiveness program.

But the bad news is that you may owe taxes on the forgiven debt, it could affect your credit score, and the process can be complicated. Learning how cancellation of debt works can help you deal with any of these issues.

What is cancellation of debt?

With debt cancellation, your creditor eliminates or forgives some or all of your debt, and they can no longer try to recover the money from you.

This is different from a charge-off, where the creditor writes the debt off on their own taxes but still pursues you for the amount you owe.

Debt cancellation can leave a scar on your credit report, with the debt remaining in your credit history, sometimes with a note that you didn’t repay the amount borrowed.

You may be able to write a goodwill letter to your creditor, asking to remove negative marks on your credit, though this doesn’t always work. It might be more successful in extreme circumstances, like repayment struggles due to a natural disaster or personal tragedy.

You will also usually have to pay taxes on the cancelled or discharged debt. This may result in a larger tax bill from the IRS than you were expecting.

Generally, debt cancellation or debt forgiveness is more likely to be offered on unsecured debts (like credit cards or student loans) rather than secured debt (like mortgages or auto loans).

How to get your debts cancelled

Unfortunately, there is no magic wand to wave away all your debts. Debt cancellation can be a complicated process, though it can still be worth it when you need debt relief.

Credit counseling

A credit counselor can help you navigate debt cancellation. They can work with you to create a debt management plan for your unsecured debts, as well as write a budget and review your credit score.

Debt management plans involve seeking a strategy to lower your interest or payments, consolidate your debts, or even get those debts fully or partially cancelled. They are usually for your unsecured debts, rather than loans that have collateral, such as a mortgage.

Your first meeting with a credit counselor should be free. If you choose to work with them, you’ll start making your monthly payments to the counselor instead of to your creditors. The counselor will then take care of paying the creditor, and may also charge you a fee, depending on your income level.

There are many scammers in this space, especially among for-profit debt settlement companies rather than credit counselors. The National Foundation for Credit Counseling can help you find a good nonprofit to work with — though remember that “nonprofit” doesn’t necessarily mean “free.”

Negotiation with creditors

If you feel comfortable negotiating with your creditors directly, you don’t need to go through a credit counselor. If you’re having trouble paying what you owe, some creditors may be willing to work with you.

While creditors are often willing to reduce your interest rate, negotiations to cancel debt will only begin after your debt is delinquent (late). Since delinquent loans can leave a negative mark on your credit report, it’s not worth being late on purpose in the hopes of working out a deal with the creditor.

Debt settlement

Whether you use a debt counselor or negotiate on your own, you probably won’t be offered debt cancellation right away. More likely, the creditor will start by suggesting an interest rate cut with a monthly payment plan for the full debt amount.

You probably won’t be offered any type of debt cancellation until you’re seriously behind in your debt. Even then, you’re unlikely to get the entire amount forgiven — instead, they may offer to cancel part of your debt in exchange for a single, lump sum payment for the rest of it.

Still, debt settlement — or partial debt cancellation — for a lump-sum payment is usually only for accounts that are way past due and have already maimed your credit.

Bankruptcy

Bankruptcy is not a decision to make lightly. The impact on your credit is severe and can last seven to 10 years. But if you’re in over your head, debt cancellation through bankruptcy may be a solution.

Personal bankruptcy generally comes in two types:

• Chapter 7 is the one people usually associate with debt cancellation. It requires you to sell off your assets, but this is done in an effort to erase your remaining debts.
• Chapter 13 is less about debt forgiveness and more about debt restructuring. It’s better for people who have secured debts, like a mortgage and might help you avoid foreclosure. It won’t necessarily cancel any debt, but you may be able to lower your monthly payments.

Student loan cancellation

If you have student loans from the federal government, you may be able to get some or all of them cancelled through a student loan forgiveness program without hurting your credit.

Some programs include:

• Public Service Loan Forgiveness (PSLF)
• Total and Permanent Disability Discharge
• Teacher Loan Forgiveness

Some, like Disability Discharge for a medical condition, can be done quickly. PSLF, on the other hand, generally takes 10 years, and forgiveness through an income-based repayment (IBR) plan can take 20 or 25 years of payments before your remainder is forgiven.

These programs are for federal student loans only. If you have private student loans, you would go through the process for unsecured debts discussed above.

Note also that federal student loans are extremely difficult to get discharged through bankruptcy.

How cancellation of debt affects taxes

Debt cancellation can hit your tax bill hard, because in most circumstances, the cancelled debt counts as income.

You’ll receive a Form 1099-C with the reportable canceled debt amount to add to your Form 1040. This is likely to push up the total amount of tax you owe for the year. It can also affect your eligibility for the Earned Income Tax Credit (EITC) and other tax benefits.

Before you enter a debt cancellation agreement, consider what you will owe in additional taxes. You don’t want to end up in a situation where you can’t afford to pay the IRS.

If you think you won’t be able to afford your tax bill, take action by proactively setting up a payment plan or compromise with the IRS, so that you can hopefully reduce the late fees or penalties.

Even with a larger tax burden, debt cancellation can still be a financial win.