Debt forgiveness is when all or part of a debt you owe is forgiven by a creditor, and it can apply to credit cards, student loans, mortgage debt, or other debt balances.
Forgiveness is often a good thing in life — but when it comes to forgiveness of debt, there are several factors to consider.
Things to know before considering debt forgiveness
Having all or part of your debt disappear seems too good to be true. Debt forgiveness is real, but debt forgiveness may not always be the best choice and even where it may look like the best option there’s still a price to pay.
Debt forgiveness goes by different names. You may also find debt forgiveness referred to as debt settlement or debt cancellation. Largely, the result is the same regardless of the name.
In many cases, however, debt settlement is a more accurate description because the process often involves paying a lower amount than what is owed, with the remaining balance being forgiven.
In other words, the borrower and creditor settle on a payment amount; the remainder is written-off. Creditors that accept debt settlements often do so to manage risk.
If they suspect they may have to sell the balance to a collection agency or settle for pennies on the dollar (or nothing) after the borrower declares bankruptcy, taking a lump sum settlement is less expensive for the lender.
For example, let’s say you have a debt of $10,000 that you’re struggling to pay the balance. After falling behind on payments, you come into some cash and offer to pay $5,000 to settle the debt. The remaining $5,000 may be forgiven by the creditor.
In some cases, however, the remaining balance may still be sold to a collection agency, so it’s important to get the settlement offer in writing with details of what happens to the debt after you make a lump sum payment.
#1 Debt forgiveness can have tax consequences
Expect most lenders to send you a 1099-C form for the forgiven amount. The IRS also gets notice of the forgiven debt and considers most types of forgiven debt to be taxable income.
For smaller debt amounts and depending on your tax bracket, this may not create a big change in taxes due — but for larger debts, you may become liable for thousands of dollars in taxes in exchange for having the debt forgiven.
The threshold for reporting debt cancellation to the IRS is $600. Expect lenders to report the total amount for debt cancellations that exceed this amount. Some types of debt forgiveness may not have tax consequences.
Certain types of debt forgiveness aren’t seen as debt cancellation by the IRS and therefore aren’t taxable, such as amounts canceled as gifts or certain qualified student loans. Be sure to check IRS rules on debt cancellation before making or accepting a debt forgiveness offer.
Other types of debt forgiveness are considered to be debt cancellation by the IRS but are excluded from income, such as debt canceled in a Title 11 bankruptcy case or debt canceled during insolvency.
It’s possible that you were insolvent before making the settlement. The IRS has worksheets to help determine solvency or insolvency when you complete your taxes.
#2 Debt forgiveness can affect your credit score
Many types of debt forgiveness can also result in derogatory marks on your credit report, which is covered in more detail later in this article. Expect your overall credit scores to drop if you have debt forgiven, although the effects may depend on the amount forgiven and the type of debt.
If you fell behind on payments before making a settlement, the lender isn’t required to remove derogatory remarks about payment delinquency. Also, your credit report is likely to reflect that the debt was settled, rather than paid in full.
Negative credit information regarding debt cancellation can stay on your credit report for up to 7 years from the first missed payment.
Credit card debt forgiveness
One of the most common types of debt forgiveness is for credit card debt. Often, credit card debt forgiveness comes as a result of working with a debt settlement agency.
However, it’s possible to reach a debt settlement arrangement directly with the credit card company on your own. Do your homework before deciding to work with a debt settlement company.
The industry is plagued by misrepresentations and many companies will suggest that you stop paying all debts while paying into a settlement fund earmarked for debt settlement offers.
This approach can cause additional negative impacts on your credit report and could have other ramifications if you aren’t able to keep up with payments to the settlement account.
Also, remember that debt settlement services aren’t free. It will cost money to settle debt using the help of a third party. If you owe $10,000 to a credit card company but aren’t able to keep making payments, the credit card company may be willing to accept an offer.
Typically, creditors are more receptive to settlement offers if you are already past due. The credit card company may be willing to accept a percentage of the total balance but it’s unlikely that the entire balance will be forgiven. Some experts recommend starting with an offer of 30%.
The credit card company may then present a counteroffer or may decline to settle if they think you can continue paying. Another strategy that some debtors use is to wait until the debt has been sold to a collection company before beginning debt forgiveness negotiations.
Debt collection companies purchase debt at a large discount. A collection company may still be able to turn a profit even with a partial payment. Beware, however, that by using this strategy, your credit report will reflect a collection in addition to any prior delinquencies you’ve had.
Student loan debt forgiveness
One of the few areas in which debt forgiveness might not lead to a tax liability is with student loans. However, whether the forgiven debt is taxable can depend on the structure of your student loan.
For student loans that do result in taxable income after loan forgiveness, the tax consequences can be massive. When compared to credit cards, for example, student loan balances can be several times higher when forgiven.
Credit card balances approaching or exceeding six figures are rare but high balances are much more common for student loans. If you meet certain criteria, the Federal Student Loan Forgiveness Program may be able to provide some relief by forgiving part or all of your remaining student loan balance.
Student loan debt forgiveness may be available to you in the following situations:
- Public Service Loan Forgiveness
- Teacher Loan Forgiveness
- Perkins Loan Cancellation (provided through your school)
- Total and Permanent Disability Discharge
- Death Discharge
- Bankruptcy Discharge (rare)
- Closed School Discharge
Like many government programs, there are a lot of rules to follow for student loans or loan forgiveness. If considering student loan debt forgiveness, study the requirements carefully and continue making payments if you choose to apply for loan forgiveness.
Many applicants are denied because they do not meet the requirements for debt forgiveness, particularly those applying under the Public Service Loan Forgiveness option.
However, if you do qualify for the Public Service Loan Forgiveness option, the IRS does not consider the forgiven debt to be income. You won’t have to pay taxes on the forgiven debt balance.
If your student loan is on an income-based repayment plan, the loan balance may be forgiven in some cases. However, expect the forgiven loan balance to be taxable income. This is where the really big tax bills can come into play.
In some cases, income-based student loan repayment plans may be structured in such a way that the balance for the student loan continues to grow. Typically, these plans require that you make payments for 20 to 25 years, after which the loan may be eligible for forgiveness.
To look at an example, with a low monthly payment — as is common with income-based repayment plans, it’s possible for a $150,000 loan to leave a remaining balance of $300,000 by the time the loan is eligible for your forgiveness.
In this case, if your $300,000 loan balance is forgiven, your taxable income for that tax year is increased by the forgiven amount. Assuming a 22% tax bracket, your tax liability on the forgiven loan balance could be nearly $70,000.
It’s likely you’ll still come out ahead mathematically when you add what you paid toward your loan and the taxes due on the forgiven amount, but the additional tax liability may come at an inopportune time.
Mortgage debt forgiveness
Another common type of debt that can become unmanageable for some households is mortgage debt, which can either be a mortgage for the primary residence or a mortgage for a secondary residence.
In many cases, mortgage debt forgiveness comes after a foreclosure or a short sale in which the proceeds from the sale of the home are less than the amount owed on the mortgage.
In the case of a foreclosure, the bank takes possession of the property, later reselling the property. In a short sale, the bank approves a sale for less than the amount owed on the mortgage for the property. In both cases, there may be an unpaid balance.
For example, let’s assume your mortgage balance is $200,000. The home is foreclosed because you haven’t been able to make payments and the lender is only able to recoup $150,000 after expenses (including collection expenses).
In this case, the lender may be forced to write off the remaining balance of $50,000. The forgiven amount may be taxable, but The Mortgage Forgiveness Debt Relief Act of 2007 permits many borrowers to exclude income that resulted from debt forgiveness for their primary residence.
Tax debt forgiveness
For tax debts, the equivalent of debt forgiveness is what the IRS calls an Offer in Compromise (OIC). Much like a settlement with a credit card company, you may be able to settle tax debts for a percentage of the amount owed.
The option to settle tax debts with an offer in compromise is subject to qualifications set by the IRS and may require an application fee.
There are three different ways in which an offer in compromise can be used:
- Ability to pay: The most common use of an offer in compromise is based on your ability to pay. Under this provision, taxpayers may be able to settle tax debts based on what they can afford to pay as opposed to what they owe.
- Doubt as to liability: if you disagree with the amount the IRS says you owe, you may be able to settle the debt for less using an offer based on doubt as to liability.
- Effective tax administration offer: A third provision of an offer in compromise may allow you to pay a lesser amount if paying the full amount would create a financial hardship in the future.
Bear in mind that the IRS will not offer these options automatically, but relief may be available if you apply and qualify.
Last resort bankruptcy
As a last resort, bankruptcy can reduce or eliminate debt. Most debt discharged in a bankruptcy is not subject to income tax. However, timing is important. You must file for bankruptcy before you receive a 1099-C from a creditor for forgiven debt.
Once there is a record of forgiven debt as income (via a 1099-C), the forgiven debt may be subject to tax. As noted earlier, in some cases, discharged debt may be excluded from your income if you’re insolvent, which means the fair market of your assets is less than you owe.
For individuals, there are two types of bankruptcy.
- A Chapter 7 bankruptcy is a liquidation of non-exempt assets to pay outstanding debt, with most remaining balances being wiped out forever.
- A Chapter 13 bankruptcy may release you from some debt or it may restructure your payments based on your income — but it can’t do both.
Here’s how a Chapter 7 bankruptcy might work:
A debtor can usually keep exempt items, such as vehicles (up to a certain value), clothing, necessary household goods, and similar necessities. Other items of value may also be exempt.
Non-exempt items become part of the bankruptcy estate and are liquidated to pay creditors. Creditors may be paid part of the remaining debt (or none) and the leftover debt balances are wiped out.
Bankruptcy is a clean slate, but it can continue to affect your finances for years to come. A bankruptcy stays on your credit report for up to 10 years, longer than other types of negative credit information.
Does debt forgiveness affect your credit score?
Debt forgiveness can affect your credit for years after the first negative event, like a late payment. At a minimum, a negative event on your credit report can linger for 7 years.
In the case of bankruptcy, expect the negative information to impact your credit for 10 years following the bankruptcy. The effect on your credit can become like a hidden tax on living because your credit can affect so many parts of modern life, such as:
- Cost of borrowing: In most cases, you can expect higher rates for new credit after you’ve made a debt settlement or a charge off. While the negative items can remain on your credit report for up to seven years — if your newer history reflects on-time payments and careful credit management, you should see interest rates start to become more attractive.
- Access to credit: In the short-term, you may be denied for certain types of loans, forcing you to consider alternate financing, like “buy here, pay here” auto loans or other types of high-interest credit.
- Job prospects: Many employers use your credit report as part of pre-employment due diligence or to assess risk for existing employees. Your credit report can affect your employment opportunities.
- Insurance rates: Many insurers also use credit information as an indicator of claim risk, assigning higher premiums to customers with negative information on their credit report.
- House or apartment hunting: Landlords also use credit reports to approve or deny tenants. The information in your credit report can also determine whether you qualify for a home loan — and if so — the loan rate. The effects of bad credit on a mortgage can cost tens of thousands of dollars over the life of the loan.
Consider the effects of debt forgiveness
When focused on the simple math of debt forgiveness, it may look like you’ll come out ahead even if the debt forgiveness results in a tax liability.
However, it’s important to consider the lingering effects of debt forgiveness, which can stay with you for 7 to 10 years and can cost money in other areas that may be difficult to measure mathematically, like missed employment opportunities, higher interest rates, and higher insurance rates.
A first step for consumers should be to look for ways to pay debts by trimming expenses or by generating more income. Before delinquencies become a problem, it’s wise to contact creditors to seek a solution.
Lenders may be willing to make adjustments to your account to make payments more affordable.