Cancellation of Debt: How It Works and Can Impact You

Cancellation of debt happens when a borrower is released from a debt obligation. However, in many cases, you may have to pay tax on the amount canceled, eliminating at least some of the benefits you’d gain. You may also have to follow strict guidelines to achieve certain types of forgiveness.

What is cancellation of debt?

Debt cancellation occurs when a creditor discharges a debt, releasing a borrower from the obligation to repay it. Unless debt cancellation comes in the form of bankruptcy or debt settlement, cancellation of debt doesn’t always impact your credit score.

However, debt cancellation may not be all good news for you. In some cases, you may have to pay taxes on canceled debt, as the government may consider it taxable income.

How to get your debt canceled

From negotiating with your creditors to filing for bankruptcy, cancellation of debt can take many forms. Which one is best for you depends on your financial situation and the status of your debt.

Creditor negotiations

Consider renegotiating the terms of a debt directly with the lender, or through a nonprofit credit counselor, which may be more feasible than full cancellation of debt in many cases.

If you’re having difficulty making your mortgage payments, for instance, your loan servicer may work with you to lower the monthly payment, interest rate or even principal balance through mortgage modification.

If you work with a credit counselor, they may create a debt management plan for you after negotiating with your creditors for provisions such as lower interest rates, dismissal of fees or smaller monthly payments.

While changing the terms of a loan may not sound as exciting as outright forgiveness, modification programs can be lifesavers when cancellation of debt isn’t an option.

Before negotiating with creditors, be sure the statute of limitations hasn’t passed on any debt you’re looking to repay. If you have any time-barred debt, the lender cannot sue you to collect it, though it can continue to call or write to you. Rules vary depending on which state you live in and the type of debt you have, so look up the statute of limitations on debt by state and loan type before attempting to negotiate with a creditor.

Debt settlement

While there are debt settlement companies that advertise the ability to negotiate on your behalf, keep in mind that working with them can be pricey, a settlement isn’t guaranteed and your creditors may refuse to work with them.

Instead, consider contacting your creditors and negotiating your own debt settlement for free.

Creditors are most likely to work with you once you’re already behind on bills; they need to know, in other words, that there’s little chance you’ll pay them in full, and settling for less is the next-best option.

You may have to pay the creditor a lump sum that’s a percentage of what you owe, or they may allow you to pay in installments.

Go into negotiations with a clear idea of what you can afford to pay, and request that the creditor note on your credit report that your debt was paid in full, rather than “settled,” if possible. That may have a less adverse effect on your credit score, since debt settlement can stay on your credit report for up to seven years. Get your agreement in writing and stick to it.

If the creditor isn’t willing to negotiate down your debt, look into other options. Debt consolidation, debt management plans and bankruptcy are all ways to manage your debts if you’re feeling overwhelmed.

  Tax debt settlement

If you have a financial hardship that prevents you from paying your taxes, you can submit an offer in compromise to the IRS, which will settle your debt for less than you owe, if approved. It can take the form of either a lump sum payment or monthly installments.

Use the IRS’ Offer in Compromise Pre-Qualifier tool to see if you’re eligible, and how much you could save by settling.

  Student loan forgiveness

Your eligibility for student loan forgiveness first depends on the type of loans you have.

Private student loans — made by banks, online lenders and credit unions — are particularly difficult to get canceled. But some private lenders have loan modification programs that can lower your monthly payment for periods of time.

Federal loans, however, come with several structured forgiveness programs. In most cases, your eligibility for forgiveness depends on your career field.

Bankruptcy

Another way to get certain types of debt wiped away is by filing for bankruptcy. It’s a route that requires deep consideration, but it can be the right choice for some.

There are two primary types of bankruptcy for individual consumers — Chapter 7 and Chapter 13. While Chapter 7 discharges your debts, in the case of Chapter 13, cancellation of the remaining debt occurs after you’ve completed a three- to five-year repayment plan.

Bankruptcy will appear on your credit report for 10 years if you file for Chapter 7 and seven years if you file for Chapter 13, which may make it difficult to qualify for new credit during that time.

If you’re considering bankruptcy, set up a consultation with a bankruptcy attorney to explore your options. You can search for a lawyer, including free legal help if your income qualifies you, through the American Bar Association.

How cancellation of debt impacts your taxes

Before agreeing to debt cancellation, you’ll want to look into whether it’s taxable or not. If it is and you have a large amount of canceled debt, you may be in for a hefty tax bill.

The IRS can consider canceled debt — the amount you were liable for but didn’t have to pay — to be taxable income, which means you’d need to report it on your tax return the year the cancellation happened.

If $600 or more of your outstanding debt was canceled, you will receive a Form 1099-C, detailing how much debt was canceled.

The canceled debt won’t be included in your income for the year, however, if the IRS considers you to be insolvent. That’s when your total debts are more than your assets. You can use the IRS’ insolvency worksheet to determine whether you met this criteria before any debt cancellation.

Why debt cancellation may not be a good fit for you

Cancellation of debt isn’t a cure-all solution. It often comes with tax burdens, fees and credit consequences that negate at least some of the benefits of forgiveness.

Also, since many creditors won’t negotiate or consider you for modification programs until after you’re behind on payments, your credit will suffer in the meantime.

Payment history comprises 35% of your FICO credit score, the largest share — that means missed payments will have a major impact.

Instead of relying on debt cancellation, take note that you’re struggling to manage your debt as early as possible, and consider these alternatives:

• Credit counseling can help you develop a budget to free up money that can go toward your debt. Credit counselors will also evaluate whether you’re a candidate for debt management, during which counselors work with creditors to reduce your interest rates and fees, making repayment more affordable.
• Debt consolidation using a personal loan or an interest-free balance transfer credit card lets you simplify payments and get a lower interest rate on credit card debt — or even take a break from paying interest altogether, in the case of some balance transfer cards. You’ll typically need good credit to qualify for the lowest rates when consolidating debt.