What Is Debt Cancellation?

What Is Cancellation of Debt?

When you take out a loan, you typically agree to pay it back in full. But in certain situations, the lender may opt to forgive some or all of the debt.

When this happens, you're no longer on the hook for the canceled amount, and you don't have to worry about the lender trying to collect again in the future. That doesn't mean there aren't any consequences, however.

How Debt Cancellation Works

There are a handful of situations where a lender may choose or be forced to cancel a debt.

Bankruptcy

When you file for bankruptcy, you're indicating that you can no longer afford to repay your debts. You'll work with a court to either liquidate your assets to repay what you can or get on a restructured payment plan. Whatever debt is left over is typically discharged by the bankruptcy court.

While bankruptcy can provide some relief, it can also severely damage your credit scores for many years to come.

Debt Settlement

If you're behind on payments, a lender or debt collector may be willing to accept a debt settlement in which you pay less than what you owe to satisfy the debt. Once you pay the agreed-upon settlement amount—usually with a lump-sum payment—the remaining debt is canceled.

Like bankruptcy, debt settlement can give you some relief amidst financial hardship, but it can have a drastic effect on your credit score.

Student Loan Forgiveness

The federal government offers several student loan forgiveness programs to provide relief for eligible student loan borrowers. In particular, the following federal loan borrowers may qualify for cancellation of their debt:

• Teachers
• Government employees
• Nonprofit employees
• Borrowers with disabilities
• Deceased borrowers
• Borrowers on an income-driven repayment plan
• Borrowers who have been defrauded

Credit Insurance

For some types of debt, including mortgage loans, auto loans, personal loans and credit cards, you may be able to purchase credit insurance from the lender.

Depending on the type of insurance you buy, the lender may cancel some or all of your debt if you pass away, become disabled or lose your job involuntarily. That said, credit insurance can be expensive, and disability and unemployment insurance may only cover a limited number of payments.

Charge-Off

If a lender has given up on collecting a debt, it may opt to charge off the balance, effectively canceling the debt.

This can also occur when a lender forecloses on a home or repossesses a vehicle, but the sales proceeds aren't enough to cover the remaining balance. While lenders will typically try to collect the deficiency balance from you, they may opt to charge off the debt if you're unable to pay.

How Does Cancellation of Debt Affect Taxes?

The IRS considers most forms of forgiven, canceled or settled debt as income for tax purposes. If the amount of your canceled debt is more than $600 and it's considered taxable, the lender is required to send you a 1099-C form, which includes the canceled amount that you'll need to report.

If your forgiven debt is less than $600, you might not get a 1099-C, but you'll still need to report it on your tax return.

Depending on how much debt has been discharged and your current tax situation, a canceled debt could result in a massive tax bill. If you've recently taken advantage of a debt forgiveness program, you'll want to find out whether the amount forgiven is taxable and how to prepare so you don't get blindsided at tax time.

Exceptions to Debt Cancellation Taxes

While most canceled debt is considered taxable income, there are some exceptions to the rule, including:

• Bankruptcy: If your debt was discharged in bankruptcy, it's not considered taxable income. The thought is that you're already hurting financially, and requiring you to pay taxes could make things even more difficult.
• Insolvency: If you're financially broke at the time of the cancellation—your liabilities exceed your assets—you may be able to exclude some or all of your canceled debt from your income on your tax return. The IRS determines how much you can exclude based on the extent of your financial insolvency.
• Gifts: If you borrowed money from your parents or a friend and they decided not to collect the full amount from you, that's considered a gift for tax purposes.
• Tax-deductible interest: If you've had a business or mortgage loan canceled, where the interest was considered tax-deductible, you won't need to report the interest portion of the forgiven amount as income. You will, however, still need to report the canceled principal amount.
• Certain student loans: Through 2025, most forms of federal student loan forgiveness aren't taxable on the federal level. However, some states may still require you to report certain types of federal loan forgiveness as income.
• Farm or real estate debt: If your debt was attached to a farm or real estate business and you meet other eligibility requirements from the IRS, you may qualify for a special exclusion.

How Does Cancellation of Debt Affect Your Credit?

Cancellation through federal student loan forgiveness or credit insurance could have a slight impact on your credit score through paying off the loan and closing the account. However, if you obtained forgiveness due to bankruptcy, debt settlement or a charge-off, you can expect your credit to take a significant hit.

That's because your payment history is the most influential factor in determining your credit score, and those types of debt cancellation are an indicator that you failed to pay as originally agreed.

With debt settlement and charge-offs, for instance, the derogatory mark will typically remain on your credit reports for seven years from your original delinquency date. With bankruptcy, the public record will stay on your credit reports for up to 10 years.

That said, these negative effects can diminish over time, especially if you take steps to rebuild your credit history.

How to Remove Canceled Debt From Your Credit Report

In general, you can't get discharged debt removed from your credit report unless the information is inaccurate. In that case, you have the right to file a dispute with the credit reporting agencies.

However, you might consider writing a letter to the creditor requesting a goodwill deletion, especially if you did everything in your power to pay what you could.

Just keep in mind that there's no guarantee the creditor will grant your request. If you can't get a negative account removed from your credit reports, it'll typically remain for seven years from the original delinquency date.

The Bottom Line

While debt cancellation may seem like a freebie, that's not always the case. Outside of federal student loan forgiveness programs and credit insurance, forgiven debt may be subject to taxes and cause significant damage to your credit.

If you're currently seeking debt cancellation through bankruptcy, debt settlement or a charge-off, research all of your options and carefully weigh both the advantages and disadvantages of each to determine the best course of action for you.

Also, be sure to monitor your credit score throughout the process to understand how canceled debt can affect your credit health and determine which steps you can take to improve your credit score over time.