Cancellation Of Debt & Related Pitfalls

If you have accumulated debts that you are unable to pay, you may be able to get your creditors to cancel your debts. This strategy can save you thousands of dollars in some cases. 

But debt cancellation can be a double-edged sword because the amount that is forgiven is then reported as taxable income and may be subject to income taxes. But you can still come out ahead if you do this. That’s because the income tax bill will be a fraction of the total amount you owed. A cancellation of debt may be just what you need to get back on your feet. 

What is debt cancellation? 

Cancellation of debt occurs when a lender writes off the debt and no longer holds the borrower responsible for paying it. This action is also known as a discharge of indebtedness, debt relief, canceled debt, forgiven debt, debt forgiveness, loan forgiveness, or cancellation of debt income. Once a debt has been canceled, the borrower is released from any obligation to make any more payments for it, meaning no further repayment is necessary. Debt forgiveness can be obtained through a debt relief program, filing for bankruptcy, or negotiating directly with creditors. 

How Debt Cancellation Works

Debt cancellation can be initiated by either the borrower or the lender. For borrowers, debt cancellation can be a godsend, as it releases them from what may have been a major financial obligation. Debt cancellation can also be beneficial for lenders as it allows them to stop their collection efforts and write off the debt. When a debt is canceled, the lender will issue a letter or statement to the borrower that says that they have relinquished the right to make any further collection efforts on the debt. By law, the borrower no longer owes them anything. 

IRS Form 1099-C

If a lender forgives a debt that exceeds $600, then the borrower (taxpayer) is required to report this to the Internal Revenue Service (IRS) on their income tax return as ordinary income. They must report this income on Form 1099-C for the tax year in which the debts were canceled. Taxpayers who fail to report this on their tax return can face civil penalties similar to those who fail to report any other type of taxable income. Borrowers should not hesitate to consult with a qualified tax professional if they have any questions about the tax law or tax implications of doing this. 

Most lenders will send a Form 1099-C to all of the borrowers whose debts they forgave during a given tax year. Lenders also report this to the IRS, so it knows who should be including debt forgiveness on their tax returns. If the IRS discovers that someone received a Form 1099-C from a lender at the end of the year and failed to report it on their tax return, then the IRS will adjust their federal income tax return to reflect this additional amount and require the necessary payment plus interest and penalties. 

Example

Frank lost his job and is unable to pay his $10,000 credit card balance. He negotiates with the credit card company and they agree to cancel this debt. At the beginning of the following year, Frank receives a Form 1099-C from the credit card company showing the amount of his canceled debt. Frank must report this as ordinary taxable income on IRS Form 1099-C on his tax return.

Debt Cancellation Exceptions

While most forgiven or canceled debt (like credit card debt or nonbusiness debt) must be reported as taxable income, there are some exceptions to this rule. That’s because the IRS doesn’t consider some types of forgiven debt to be classified as income to the borrower. On the other hand, other types of cancellations are considered to be formal cancellations of debt but are not included in gross income. The IRS has a full list of exceptions and exclusions.

Those who have a qualified exclusion must file Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness. This form allows taxpayers to determine how much of their debts they can exclude from their gross income for that calendar year. 

Bankruptcy

Bankruptcy is perhaps the most straightforward and thorough method that borrowers can use to cancel their debts. This legal process will absolve the borrower from having to repay most of their debts. Some exceptions are back taxes, court-ordered payments, and some types of student loans. Bankruptcy also prevents lenders from pursuing any further collection efforts. The lenders have no choice but to forgive the borrower’s debts. 

Chapter 7 vs. Chapter 13 Bankruptcy

There are two main types of bankruptcy: Chapter 7 and Chapter 11. In a Chapter 7 bankruptcy all of a borrower’s debts are forgiven and no repayment of any kind is required. But it will stay on your credit report for a longer period of time. In Chapter 13 bankruptcy, the court will stop all collection efforts and require borrowers to follow a five-year debt repayment plan. Chapter 7 bankruptcies will stay on the borrower’s credit report for 10 years while a Chapter 13 bankruptcy will remain on there for only seven years. 

Student Loan Forgiveness

There are many programs available that can help borrowers discharge their student loan balances, though they often have strict requirements. Educators and public servants can get their student loans forgiven if they work in their field for a certain period of time. They must also make their loan payments on time without fail during this period. 

Borrowers can also have a portion of their student loans forgiven through the Pay-As-You-Earn Program (PAYE). This program caps the borrower’s loan payments at 10% of their discretionary income. As long as the borrower makes their payments on time, without fail for a certain period of time, the remainder of the loan balance is forgiven. 

Insolvency

The IRS considers individuals who have more liabilities than assets to be insolvent. Insolvent taxpayers are generally not required to include forgiven debt as income, but they must claim insolvency by filing tax Form 982 with the IRS. 

Farm Or Real Estate Debt Exclusion

Debt that is accrued and discharged from a farming or agricultural operation does not count under the IRS insolvency rule. The same is true of real estate debts. They can never be discharged in a Title 11 bankruptcy case. The IRS does exclude farm and real estate debt in some cases, but there are requirements. 

The Qualified Principal Residence Exclusion applies to any debt incurred for the purchase of a principal residence between 2006 and the end of 2020. Any mortgage debt that is incurred to buy, build, or substantially improve the borrower’s primary residence up to $2 million is eligible for this exclusion if the taxpayer is filing as a married couple. Taxpayers who file as single or as married but filing separately are eligible to exclude up to $1 million of this debt. But if only part of the loan being discharged was used to buy, build, or improve the primary residence, then only the portion that was NOT used to do this will count. 

For example, the borrower’s main home is secured by a mortgage debt of $1 million. But only $850,000 of this counts as qualified principal residence indebtedness. If they sell the home for $700,000, then $300,000 of this debt is discharged. But only $150,000 of this debt will be excluded from income. The $300,000 of mortgage debt that was discharged, minus the $150,000 of nonqualified debt, leaves $150,000 that can legally be excluded from the borrower’s income for that year. The fair market value of the home is also an important variable in this case. 

Another key exclusion applies to qualified real property debt that was discharged in the course of running a business. If a taxpayer receives a discharge of indebtedness related to qualified real property business indebtedness, then this exclusion applies to the extent that the debt was incurred by the taxpayer in connection with using this property for a qualified trade or business. “Qualified acquisition indebtedness” refers to any amount of money used to buy, build, or improve the said property. Any amount that is excluded under this provision is then used to reduce the cost basis of the property accordingly. 

Other Exceptions

There are several other types of indebtedness that are not counted as taxable income. These debts include:

• Debts that are canceled as a gift or inheritance

• Some student loans that meet specific criteria (mentioned above)

• Educational loans that are used to provide for certain types of healthcare services

• Canceled debts that would be payable if the borrower was a cash-basis taxpayer

• A qualified reduction of the purchase price of a property that was provided by the seller

• Mortgage payments under a Pay-for-Performance Success program that are used to reduce the amount of principal under the Home Affordable Mortgage Program

• The balance of any student loans that are forgiven due to the death or disability of the borrower

• Canceled debt that is not counted if the borrower would have paid it as a “cash-basis” taxpayer

• Payments made for relief programs that help to provide healthcare services

Debt Cancellation Methods

There are several different ways borrowers can cancel some or all of their debts. What’s best for you will depend on your circumstances and what you can afford. It’s best to seek legal advice before proceeding.

If you have the money to hire a lawyer, you may choose to file bankruptcy. A good bankruptcy attorney can tell you exactly what your options are and which avenue is best for you in your current situation. This advice can be invaluable in many instances and may save you thousands of dollars in the long run. If you have a simple Chapter 7 bankruptcy case, you may be able to use our online tool to file without the help of an attorney.

Negotiating With The Lender/Creditor

This is perhaps the most straightforward method of dealing with debt. A borrower can contact their lender and ask them to forgive some or all of their debt or negotiate to pay a lesser amount upfront. For most lenders, getting something is better than getting nothing, which is why this strategy can be effective. Negotiating allows you to escape having to pay at least a portion of the debt you owe, but you’ll need a chunk of changer to be able to do this. Understandably, that’s something that many borrowers do not have. 

Those who have no savings to fall back on can beg for the lender’s mercy, which may or may not work. And getting creditors to knock off late fees and penalties can be difficult in many cases because these are their primary sources of revenue. But this is still the simplest and cheapest way to deal with indebtedness in most cases.

Homeowners may be able to negotiate a lower mortgage payment with their lender, as most lenders would rather get a smaller payment every month than go through the process of foreclosure. Many home lenders have ready-made programs for this type of adjustment, so borrowers should be sure to ask their lenders what they can offer. 

Filing For Bankruptcy

Bankruptcy should generally be viewed as a last resort for dealing with debt. But this is often the only way out for many borrowers who have become buried under a mountain of bills that they are unable to pay. The key factor to consider here is whether the borrower should file for Chapter 7 or Chapter 13 bankruptcy. The former choice is the more severe measure of the two and will stay on the borrower’s credit report for 10 years. The latter option will stay on the borrower’s credit report for only seven years—after a five-year repayment plan has been completed. 

Using Debt Relief Programs

There are many different debt relief and debt settlement programs available throughout the country. A qualified credit counseling service can advise debtors on which program would be the best choice for them, depending upon their current circumstances and income. Debt settlement companies are for-profit organizations that will negotiate directly with the borrower’s creditors. They try to reduce late fees and other penalties so that the borrower can make lower monthly payments. But there are many details that must be considered when using one of these companies. And the settlement process can take a long time in many cases. 

Debt relief companies usually require the borrower to stop making payments on their debts so that their creditors will be more likely to settle for a lesser amount. But borrowers must often continue making payments into an escrow account that is eventually used to pay off the settlement amount. 

Let’s Summarize

Debt management is a key aspect of personal finance. If you need debt relief, you have several options, including debt settlement, loan forgiveness, mortgage reduction, and bankruptcy. Having a mortgage is often one of the biggest debts people take on. If you’re struggling to make your monthly payments, ask your lender about what programs they can offer to help.

Remember that if a creditor does agree to forgive your debt, you may have to report that as taxable income to the IRS.  If you’re unsure if your forgiven debts are taxable, you can consult the IRS.