Debt Cancellation

Debt cancellation summary: 

• Debt cancellation occurs when your lender wipes out some or all of a debt. This can be managed through bankruptcy, debt settlement or a student loan forgiveness program.

• Settlement or government programs could help lighten your debt load and get you back on track.

• Canceled debt doesn’t always mean a tax liability if you qualify for insolvency or file bankruptcy.

Debt Cancellation Definition and Meaning

Debt cancellation occurs when creditors forgive what you owe. Companies may be willing to forgive debt when you’re unable to pay. How to best cancel debt depends on your debt type (student loan, credit card) and debt load (how much you owe). Bankruptcy and settlement are common methods.

Types of Debt Cancellation

Bankruptcy, settlement, and government forgiveness programs are some of the most common types of debt cancellation, also known as debt relief. Most methods have some impact on your credit score for a time. 

Bankruptcy. Forgives most unsecured debt in full when you qualify for Chapter 7. Bankruptcy stops all debt collection calls because debt collectors cannot legally pursue you for any debt included in the filing. Chapter 7 may force you to surrender your assets (property you own) to the court, while Chapter 13 commits you to a repayment schedule for three to five years.

Settlement. Forgives some debt if you successfully negotiate with creditors, who agree to accept less than you owe as payment in full. Settlement lets you get rid of a portion of what you owe. You can DIY settlement or pay a professional debt settlement company to negotiate for you. 

Government forgiveness program. Forgives federal student loan debt when you qualify and complete the program. There’s usually no negative impact to your credit score. 

Similarly, if you negotiate your tax debt through the IRS’s Offer in Compromise program, that typically has no impact on your credit score.

Another type of debt cancellation is mortgage foreclosure, when you default on a home loan and your lender repossesses your house. In most cases, you won’t be responsible for the difference if the lender sells the home for less than what’s owed. 

Debt cancellation and taxes

Canceled debt is generally taxable as income. Amounts of $600 or more are reported on Form 1099-C, unless the debt is cleared through bankruptcy, insolvency, or certain student loan forgiveness programs. 

Exceptions include debts canceled as gifts, certain qualified student loans, and others.

Real-Life Examples of Debt Cancellation

These scenarios show how debt cancellation works in a number of individual situations.

Bankruptcy 

Sarah, a single parent, lost her job and has $30,000 in credit card debt and $10,000 in medical bills she can’t pay. She files for Chapter 7 bankruptcy. Her non-exempt properties (for example, a second car) are sold to repay creditors, raising $5,000. The court discharges the remaining $35,000 in debt, meaning Sarah no longer owes anything.

Settlement 

John owes $20,000 on a credit card but can’t make the payments because of his reduced income. He hires a debt settlement company, which negotiates with the creditor. The creditor agrees to accept a lump-sum payment of $8,000, forgiving the remaining $12,000. John pays the $8,000, and the $12,000 is canceled.

Government program 

Maria, a public school teacher, has $50,000 in federal student loans. She enrolls in the Public Service Loan Forgiveness (PSLF) program and makes 120 qualifying payments (10 years) under an income-driven repayment plan while working full-time at a public school. The remaining $30,000 balance is forgiven, and Maria owes nothing further.

Foreclosure 

Mike is a recently-divorced homeowner who can’t afford his mortgage payments. The lender forecloses on the home, which has a $200,000 mortgage balance, and sells it at auction for $150,000. The remaining $50,000 of mortgage debt is canceled by the lender. Mike now owes nothing.