Drowning in debt? If so, you probably wish your obligations would simply disappear, with fate stepping in to give you a giant “do-over.”
While that might sound like a fantasy, in some situations, debt cancellation is possible.
How Does Debt Cancellation Work?
Unlike debt consolidation loans or credit counseling programs — which at best typically help you lower the interest rates on some of your outstanding debts — debt cancellation can actually reduce or eliminate the amount of money, you owe to creditors.
Some debts that may be eligible for debt cancellation include:
- Credit card debt and store credit lines
- Medical bills
- Judgments
- Student loans
Methods Of Debt Cancellation
According to the Federal Trade Commission, most people who seek debt cancellation turn to a for-profit company that negotiates with the borrower’s creditors. The goal is to secure an agreement in which you pay a “settlement” lump sum that is less than the total amount of money you owe. This ends your obligation to pay off the remainder of the debt.
In preparing to make your lump sum payment, these debt relief companies typically will ask you to set aside money each month that will be held in an account. This money eventually will be used to pay off the negotiated settlement amount.
During this part of the process, you may be asked to stop making monthly payments to your creditors. This puts more pressure on the creditors to make a deal and cancel some or all of the debt.
Student Loan Debt Cancellation
In other situations, debt cancellation might be part of a formal program. For example, students who take out federal loans to finance their education may be eligible for partial or total cancellation of their debt in exchange for participating in in-service programs.
Debts tied to medical school and other health-profession studies also may be canceled for those who agree to work in ways that help underserved populations.
“An example would be completing a nursing degree and then working for a specified period of time in an underserved area,” says Melanie McCoskey, an associate professor in the George Daverio School of Accountancy at the University of Akron in Ohio.
Graduates who work for the government or a not-for-profit organization may be eligible to receive loan forgiveness under the Public Service Loan Forgiveness program.
Teachers employed full-time for five consecutive years in a low-income elementary school, secondary school, or educational service agency may be eligible for forgiveness of up to $17,500 on their Direct Loan or FFEL Program loans.
How Debt Cancellation Affects Your Taxes
While debt cancellation can help you eliminate a source of enormous financial strain, it’s a mistake to think you won’t pay a price for settling your debt.
“The cancellation of debt is generally a taxable event,” McCoskey says.
While not every type of canceled debt requires you to pay taxes, many do.
The Internal Revenue Service considers forgiven debt of $600 or more to be income for income tax purposes. If your canceled debt falls under this definition, you’ll receive a Form 1099-C, Cancellation of Debt, from the lender that forgave the debt.
You must report any canceled debt — including debts of less than $600 — on your income tax return.
However, in addition to debts under $600, there are other circumstances where you may not actually be required to pay taxes on the forgiven obligation. For example, if you are insolvent — meaning you have liabilities greater than your assets — you will not owe tax.
To illustrate, McCoskey uses the example of a taxpayer who has assets of $100,000 and liabilities of $130,000. If the taxpayer’s credit card company forgives the taxpayer’s $20,000 credit card liability, the taxpayer is still insolvent, with assets of $100,000 and remaining liabilities of $110,000.
“In this case, the taxpayer will not report any taxable income from the discharge of the indebtedness,” McCoskey says.
It’s important to note that the credit card company would still send a Form 1099-C, Cancellation of Debt, reporting the $20,000 debt forgiveness. If this happens to you, McCoskey notes that IRS Publication 4681 includes information and a worksheet to help you determine if you meet the insolvency exception that allows you to avoid paying taxes on the forgiven debt.
In addition, some — but not all — types of student loan forgiveness are excluded from taxable income. This includes student loans for certain professions if the borrower meets specific requirements.
It’s also likely you won’t owe taxes on canceled debt in the following situations:
- The debt was discharged as part of a bankruptcy
- You borrowed money from family or friends and they told you not to pay it back
- You have debt attached to a farm or real estate business and you meet certain eligibility requirements from the IRS
Debt Cancellation Options
As the IRS notes, “cancellation of debt is a complex topic.” For that reason, it usually makes sense to consult with a tax professional or attorney before pursuing this route.
You can try to negotiate directly with a creditor to have your debt canceled, but this can be a difficult process. The Consumer Financial Protection Bureau also suggests working with a nonprofit credit counselor who can help you explore your options.
If you decide to work with a debt relief company, make sure you know your rights. The Federal Trade Commission has ruled that debt relief companies can’t charge you any fees until the company:
- Renegotiates settles, reduces, or otherwise changes the terms of at least one of your debts
- Reaches an agreement between you and the creditor or debt collector that you agree to accept
Debt Relief Programs
In addition, you have to make at least one payment from your repayment plan to the creditor before the debt relief company can charge you.
Also, fully understand the risks associated with using a debt settlement company. The CPFB warns that debt settlement companies sometimes charge high fees. In addition, if the debt settlement company asks you to end payments to your creditors, you face the risks of:
- Owing late fees and penalty charges
- Seeing your credit score decline
- Ending up being sued
The agency also urges you to beware of debt relief scams. In particular, be wary of any company that charges you fees upfront in exchange for the promise to get your debts canceled.
Also, beware of debt relief companies that “guarantee” they will save you a specific amount of money or a specific percentage of your debt. Another red flag is when a debt settlement company promises to settle the debt within a specific amount of time.
However, you settle your debt, make sure the obligation no longer appears on your credit report. Some experts note that even after a creditor forgives a debt, the obligation can remain on your credit report as being collectible. This can happen when the creditor fails to alert the credit-reporting agencies to the fact that the debt has been forgiven.
In a worst-case scenario, a debt collector may continue to pursue the debt long after the creditor has agreed to cancel it. If this happens to you, consider contacting an attorney who specializes in consumer protection and can help you resolve the issue or provide legal advice.
At National Debt Relief, we take pride in empowering people to regain their financial stability through our proven debt relief program. Contact us and talk to a financial expert who will work with you to find the best option to settle your debt and help you achieve financial independence.