What is Cancellation of Debt and What's the Catch?
Cancellation of debt happens when a creditor alleviates a debtor from the obligation. It’s possible for debtors to discuss with a creditor directly in order to get debt forgiveness. It’s also possible to get cancellation of debt through a debt relief program or with a bankruptcy filing. Canceled debt is usually recorded by the creditor and reported as income, and is also taxable as income.
Exceptions to Cancellation of Debt
There are some exceptions when it comes to canceling certain debts. According to the IRS, there are some that won’t be considered. This includes some qualified student loans, education loans, or relief programs that provide health services, canceled debt that would be considered deductible if an individual paid it, qualified purchase price reduction on the property provided by a seller, inheritance or debts canceled as gifts, and student loans discharged upon the disability or death of the student.
Canceled Debt and Taxes
Even if a debt is canceled, the IRS considers most forms of settled or canceled debt as income when it comes to paying taxes. If the amount of your canceled debt exceeds $600 then it is considered taxable and the lender will send you a 1099-C form. This form includes the amount of debt canceled and you will need to report it when you file your taxes. Even if the debt is forgiven is less than this $600 limit and you don’t get a 1099-C, you will still have to report it.
Depending on your current tax situation and how much debt was canceled, this could mean a big tax bill. If you have taken advantage of a debt forgiveness program then you need to know if the debt is taxable and be prepared so you aren’t blindsided when filing your taxes.
There will be a few exceptions to this. If your situation is under these certain categories then you may be required to report the debt but it won’t be counted toward gross income:
Bankruptcy
If you use bankruptcy as a method to discharge your debt then this won’t be considered taxable income. If you have turned to bankruptcy then you are already likely to be hurting financially so being required to pay more taxes can make things even harder.
Insolvency
If you are broke financially at the time of debt cancellation and liabilities exceed assets then it could be possible to exclude some or all of the canceled debt from income on your tax return. The IRS will determine how much you are able to exclude based on the extent of insolvency.
Gifts
If you have borrowed money from a friend or family member and he or she decides not to collect the full amount then this is considered a gift when it comes to tax time.
Tax Deductible Interest
If you have a mortgage or business loan canceled and the interest was tax-deductible then you don’t need to report the interest part as income. You will need to report the canceled principal amount.
Some Student Loans
If your student loans were forgiven due to your service in a specific career or field for a set period of time then this won’t be considered taxable income.
Real Estate or Farm Debt
If a debt was attached to a real estate business or farm and you have met the other requirements for eligibility by the IRS then you may get a special exclusion.
Different Methods of Cancellation of Debt
There are different ways to get debt canceled. Each method has its own unique set of challenges and advantages if it can work for you.
Negotiating with Creditors
This can be one of the most challenging ways to cancel debt. Many creators are not willing to cancel individual debts because fees and interest are the main sources of their income. There are some creditors that do allow provisions in the agreement for canceled debt. There are also many creditors that do have credit relief services, which have a small additional fee and are used for specific hardships, such as medical occurrences or job loss.
Before you begin negotiating with creditors, it helps to review the credit card terms of your creditors to see if there is anything that can easily be done for debt cancellation. Certain loans that are issued under a government program can have a higher chance of debt forgiveness. These include mortgage loans and student loans that are eligible under relief programs sponsored by the government. Some lenders are also willing to negotiate a principal reduction on a mortgage loan since this saves them some of the costs of foreclosure and still allows them to make money.
Debt Relief Programs
Debt settlement and relief programs can be accessed across the nation to help with the cancellation of debt. Working with different credit counseling resources can also help you find the right program for your situation. A debt settlement company is a for-profit company that works on behalf of you to negotiate a settlement with your creditors. There are plenty of different caveats to working with these companies and the process can actually take years.
It can be a good option for you if you have been delinquent on payments for years though. When you work with a debt settlement company, they will look at your entire credit profile and then contact creditors on your behalf for debt forgiveness. With these programs, you are requested to stop payments on your monthly credit bills in order to increase your likelihood that a creditor will settle. Then they require you to make payments to an escrow account and they will put a lump sum toward your debt, which is paid in the future.
Bankruptcy
Bankruptcy is usually a last resort but can be a good option for a distressed borrower, as long as you are getting proper debt advice. With bankruptcy, you would have the support of the courts and an attorney. Debt forgiveness won’t be considered taxable income in bankruptcy, which helps with tax liabilities. However, bankruptcy can be a complicated process and there are a lot of impacts that will follow you for years to come. It’s worth speaking with a lawyer and an accountant before you go down this route.
Tax Debt Settlement
The above methods are more likely to work for credit card debt. However, if you have a large tax bill, it can be overwhelming and you may need some help with it. The tax payment will only get larger if you aren’t paying it by the deadline, due to late fees and interest charges. You may want to consider getting tax debt relief straight from the IRS or consider making installment payments. If you are capable of paying taxes within 120 days or over a longer period of time with installments then the IRS probably won’t qualify you for settlement of tax debt.
You then have two options. You can do a short-term payment plan, which gives you 120 days. There are no setup charges but you do have fees and interest until you have paid the balance in full.
If you aren’t able to do it in 120 days then you can get a long-term repayment plan. It will cost money to set up and, just like the short term plan, you will still have to pay fees and interest until your debt is paid off. If there is a financial hardship that is causing you to not be able to pay your taxes then you can submit an offer to the IRS. This can help you settle for less than you owe. It can either be in monthly installments or a lump sum payment. You can use the Offer in Compromise Pre-Qualifier tool from the IRS to see if would be eligible for this and how much you are able to save by settling your tax debt.
Student Loan Forgiveness
There are many different kinds of student loans so your eligibility when it comes to settling student loan debt will vary, depending on what kind of loan you have. Private loans made by credit unions, online lenders, and banks may be harder to get canceled. Some private loan lenders do have loan modification programs that will allow you to lower monthly payments for a period of time while you are struggling. Federal loans do have more options for canceled debt. Eligibility will depend on the job you are in.
- Public Service Loan Forgiveness: This is for public service employees that are eligible for the remainder of their loan balance forgiven after 10 years of payments on a loan plan that qualifies them. The forgiven loan amount is not taxable. It’s designed for borrowers who work full time for a qualifying organization, it will generally have to be a government or nonprofit agency and they do still need to pay loans on an income-driven plan.
- Teacher Loan Forgiveness: Secondary science and math teachers, as well as special education teachers, can be eligible for up to $17,500 in forgiveness. Other teachers are eligible for up to $5,000. You need to still pay five years in order to have the maximum amount of loan forgiveness. Borrowers also need to have a state teacher certification and at least a bachelor’s degree, teach at a school that serves low-income students and have federal family education loans or direct loans.
- Perkins Loan Cancellation: Firefighters, nurses, teachers, and other public service employees can get up to all of their Perkins loans cancelled. It takes five years in order to get the maximum amount. Borrowers need to be in a qualifying public loan occupation. Perkins loans may also be cancelled if there is a total and permanent disability of the borrower, the borrower dies, or if the borrower’s school closed before studies were finished.
- Income-Driven Repayment: With an income-driven repayment plan, borrowers can pay 10% to 20% of their discretionary income for 20 to 25 years then get forgiveness on the remaining balance. There are four separate plans to consider for this so it’s necessary to explore the individual requirements for each. Any borrower that has federal loans can qualify for this type of repayment. However, in order to be eligible, you will need to show that you aren’t able to afford a standard 10-year repayment plan. The forgiveness amount is still taxable.
- Death Discharge: Federal student loans are cancelled if a parent or student borrower dies. Discharge only happens once there is a copy of the death certificate. The cancelled debt is not taxable.
Difference between Debt Settlement and Cancelled Debt
Settling debt for less than you owe and having debt canceled are a little different:
Debt forgiveness usually happens as part of a specific program but debt settlement happens when you are already struggling to pay what you owe and are behind on payments.
Debt settlement may only be available for unsecured debt, such as personal loans and credit cards. Your credit may already be in bad shape and settling debt can damage credit even more.
Debt cancellation may not have an impact on your credit score.
In both cases, you will have to report the debt as income on your tax return.
Be Prepared for the Tax Bill
While debt cancellation can seem like a great thing when drowning in debt, the sooner you find out about the tax implications, the better off you will be. It’s best to speak with a tax professional to find out whether or not you need to qualify for an exception. If you do then you won’t need to do anything else. However, if you don’t get an exception then you need to start preparing for the tax bill.
Again, a tax professional can help you run numbers based on which deductions and credits you qualify for and how much tax you are currently having withheld from your paycheck. It’s likely that you may end up owing money, especially if you had a lot of debt canceled. If you do end up owing money then start working on a savings plan so you can make sure that you can afford it. The IRS does offer installment plans for those who aren't able to afford to pay by the due date, but they will charge interest and a penalty until you do pay in full.
Don’t Drown In Debt. The Debtry Shop Will Help You.
Why You May Not Want Your Debt Cancelled
Debt cancellation can seem great but it’s not a cure-all. There will be tax burdens, credit consequences, and fees that may even negate some of the benefits of debt forgiveness. Many creditors won’t even begin the negotiation process until you are behind on payments so your credit is going to suffer in the meantime. Keep in mind that payment history is 35% of your credit score and the largest share so missed payments do have a big impact. Even if you are committed to trying debt cancellation, you shouldn’t pin all your hopes on success. You may want to consider other options if debt cancellation doesn’t work out the way you wanted to.
What to Do Instead of Debt Cancellation
If you have tried debt cancellation and it didn’t turn out like you hoped, or you still want to have some other options, there are different alternatives you can consider.
Credit Counseling
With the help of credit counseling, you can develop a budget in order to free up money that can go toward paying down your debt. A credit counselor will help you evaluate if you are a candidate for debt management, which is when the counselors will work with creditors in order to reduce your fees and interest rate and make your payment something you can handle.
Debt Consolidation
Debt consolidation involves using a personal loan or a balance transfer credit card with no interest to simplify payments and get a lower interest rate. In the event that you are using a no-interest credit card, you may even get a break from paying any interest. You will usually need good credit to get a lower interest rate but this is still a possibility instead of debt cancellation.
In general, making thoughtful choices with debt and your borrowing will prevent you from having to explore this option. It will help to identify a budgeting strategy that works for you or rely on a budgeting app. If you are currently in debt, there are some ways to get out of it and you would be smart to explore those. However, over the long term, it’s a better option to start watching what you are spending and stay on top of your debt.
To Sum Up,
Cancellation of debt may not always be an option but it can work for some people. Before you consider canceling your debt, you need to find out if your debt is eligible to be canceled, the different methods you can go about doing so, and how it’s going to affect your taxes. Most canceled debt is still going to be taxable so if you aren’t careful, you can wind up with a big tax bill that you aren’t expecting and get into more trouble with debt. There are other options besides cancellation of debt and having a solid budget can prevent you from getting too far into your debt in the first place.