Everything you need to know about cancellation of debt (COD)

You can get debt canceled, but there will likely be tax or credit implications

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Having an overwhelming amount of debt can make it seem impossible to ever improve your financial situation. After all, too much unpaid debt can result in too many bills — and it can be difficult to pay all of them while also keeping a roof over your head.

Often, getting help from a third party is the best course of action at this point, whether you opt for the assistance of a credit counseling agency, work with a debt settlement company or take the first steps toward bankruptcy. In the last two scenarios, you may be able to have some of your debts canceled altogether through a process called "cancellation of debt” (COD).


Key takeaways

  • Cancellation of debt happens when a creditor agrees to settle or cancel a debt for less than the amount owed.
  • In most cases, canceled debt is considered taxable income if the amount is over $600.
  • Common strategies include debt settlement and Chapter 7 bankruptcy, although educational debt comes with its own separate forgiveness programs.

What does cancellation of debt mean?

According to financial attorney Leslie H. Tayne of Tayne Law Group, cancellation of debt is also known as debt forgiveness.

"It’s reducing what you owe to a lower or zero balance," she said.

However, COD doesn't happen automatically, and there are numerous steps that need to take place before creditors will wipe away a debt completely. There are also only a few strategies in which debt cancellation can even occur, Tayne said.

Debt cancellation can happen via debt settlement, where you negotiate a reduced balance with your creditor," she said. "It can also occur when debts get discharged in Chapter 7 bankruptcy."

Educational debt can also be canceled through various student loan relief and forgiveness programs.

Debt settlement
Debt settlement is a debt negotiation strategy offered by third-party debt relief companies that promise to help you settle debts for less than you owe. These companies ask you to stop making payments toward your debts when you begin their programs and to make payments to a savings account in your name instead.

Theoretically, the funds in that account will be used to settle debts for less than you owe later on in the program. However, debt settlement comes with certain risks , including the risk that creditors won't negotiate. Also, stopping bill payments during the debt settlement process can cause considerable damage to your credit score.

» COMPARE: Best debt settlement companies

Chapter 7 bankruptcy
While there are other types of bankruptcy to consider, including Chapter 13 bankruptcy, Chapter 7 bankruptcy is the type that can lead to COD. According to the Federal Trade Commission (FTC), Chapter 7 bankruptcy leads to the liquidation of all your assets that aren't exempt, which may include cars, tools for work and basic items needed for your home.

Liquidated assets are then sold off to help repay your debts. Many remaining debts can also be wiped away completely during bankruptcy, giving you a fresh start. Of course, Chapter 7 bankruptcy will harm your credit score dramatically and stay on your credit reports for 10 years.

Educational debt forgiveness
Several student debt forgiveness programs are available for federal student loans only (not private student loans). The most popular of these are income-driven repayment plans that let borrowers make payments based on their income and family size for 20 to 25 years before having remaining debts forgiven.

Public Service Loan Forgiveness (PSLF) is another plan for borrowers who work in eligible public service positions and repay their loans on an income-driven plan. These plans lead to forgiveness of remaining debt after 10 years provided all work and payment requirements are met.

Other educational debt forgiveness programs can be state-based or based on the industry someone works in. Teacher Loan Forgiveness for federal student loans is an example of a program geared to borrowers in a specific occupation.

Is cancellation of debt taxable?

According to Tayne, the IRS views any debt canceled over $600 as taxable income. This means having debt forgiven requires you to fill out and submit another form when you file your taxes for the year the debt was forgiven or wiped away.

"Your creditor should provide tax form 1099-C to file with your tax return for the year the debt was forgiven," she said.

Tayne says the biggest consequence of this is the fact your tax bill could be higher than you expected.

"Knowing this, you should try to set aside the funds to cover this expense before you file your tax return," she said. "If you can’t pay the tax balance due, you should contact the IRS as soon as possible to work out alternate arrangements, like a payment plan."

There are notable exceptions when it comes to taxes on canceled debt, specifically regarding federal student loans. First off, debt forgiven through PSLF is not considered taxable income for IRS purposes. And while debts forgiven through income-driven repayment plans for federal student loans are normally considered taxable income, this is currently on pause under President Joe Biden's American Rescue Plan, which temporarily exempts debt forgiven through income-driven plans from taxation through 2025.

» MORE: How to file your taxes for free

How to remove canceled debt from your credit report

While having debt that's been wiped away removed from your credit history seems like a good idea, this isn't possible. Tayne says that your canceled debt doesn’t get erased from your credit history just because you no longer owe it.

"It will still appear on your credit report until it naturally falls off," she said, adding that the threshold where negative information falls off credit reports is seven years.

However, your report should reflect the account’s current status, such as “settled for less than the full amount” if a portion of the balance got forgiven via debt settlement.

» COMPARE: Best debt relief companies

Could your debt be reduced or forgiven? Take our financial relief quiz.

    FAQ

    What is a 1099-C?

    Form 1099-C is the form a company gives you when you have some or all of your debts canceled. This form is required when forgiven debt amounts are $600 or higher, although some exceptions apply for educational debt.

    What happens when you get a cancellation of debt?

    Having debt canceled can make it easier to get back on track with your finances, but you will likely owe taxes on forgiven amounts of $600 or more. If you do, you'll be given a Form 1099-C by the creditor that forgave the debt, and you'll submit this form when you file your taxes for the year the debt was forgiven.

    When is cancellation of debt not taxable?

    Canceled debt may not be taxable in some situations, including certain types of educational debt being forgiven. For example, federal student loans forgiven through PSLF are not considered taxable income. Debts forgiven through income-driven repayment plans are exempt from taxation through 2025, thanks to the American Rescue Plan of 2021.

    Bottom line

    Cancellation of debt can help you get out of debt for less than you owe, but the process can be more difficult than people realize. For example, both debt settlement and bankruptcy come with a range of long-term consequences for your finances and your credit. And, even if you do get debt wiped away, you'll likely owe income tax on forgiven amounts.


    Article sources
    ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
    1. U.S. Department of Education, “ Public Service Loan Forgiveness .” Accessed Sept. 29, 2023.
    2. U.S. Department of Education, “ Income-Driven Repayment Plans .” Accessed Sept. 29, 2023.
    3. Federal Trade Commission, " How To Get Out of Debt ." Accessed Sept. 29, 2023.
    4. U.S. Department of Education, “ Teacher Loan Forgiveness .” Accessed Sept. 29, 2023.
    5. U.S. Department of Education, “ Complete the Public Service Loan Forgiveness (PSLF) Form With the PSLF Help Tool .” Accessed Sept. 29, 2023.
    6. Tax Foundation, " Inconsistent Tax Treatment of Student Loan Debt Forgiveness Creates Confusion ." Accessed Sept. 29, 2023.
    7. Consumer Financial Protection Bureau, " How long does negative information remain on my credit report? " Accessed Sept. 29, 2023.
    8. IRS, " About Form 1099-C, Cancellation of Debt ." Accessed Sept. 30, 2023.
    9. The White House, " President Biden Announces American Rescue Plan ." Accessed Sept. 30, 2023.
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