Cancellation of Debt (COD): Definition, How It Works, How to Apply

What Is Cancellation of Debt?

Cancellation of debt, sometimes referred to simply as debt cancellation, occurs when a creditor relieves a borrower from a debt obligation. You may be able to negotiate directly with a creditor for debt forgiveness, or you can use a debt relief company.

Alternatives to debt cancellation may be establishing a debt management plan or filing for bankruptcy.

Debts forgiven by a creditor are generally considered taxable income. Canceled debt will typically be reported by the creditor to the Internal Revenue Service (IRS) and to the debtor on a 1099-C form.

How Debt Cancellation Works

Debts may be canceled in a variety of ways, including through negotiations between the creditor and the debtor, debt relief programs, and personal bankruptcy. Debts forgiven by a creditor are generally considered taxable income. Canceled debt will typically be reported by the creditor to the IRS and to the debtor on a 1099-C form.

Here is a more detailed look at each of the options for canceling debt, and the pros and cons of each.

Negotiating with Creditors

Negotiating a cancellation of debt with a creditor can be challenging because creditors want the full amount of money they are due. However, a creditor may be open to canceling a portion of the debt if you are seriously delinquent in your payments and you agree to repay some of it. Some creditors also have provisions in their credit agreements for canceled debt.

Many creditors also have credit relief services that are available for a small additional fee and come into play in specific hardship situations such as a job loss or serious illness.

Certain loans issued under government programs may have a higher chance of debt forgiveness. These loans can include federal student loans and mortgage loans eligible for debt forgiveness under government-sponsored relief programs.

In the case of mortgages, some lenders may also be willing to negotiate principal reductions because that can be less expensive for them than initiating a foreclosure.

Debt Relief Programs

Reputable debt relief and settlement companies can also help with debt forgiveness.

Debt settlement companies are for-profit entities that work on behalf of a borrower to negotiate with creditors. Borrowers should make sure that they are dealing with a legitimate one and be aware that the settlement process may take years. However, debt settlement can be a helpful option for borrowers who have been steadily delinquent in payments and see no way of catching up.

Debt settlement companies will assess your entire credit profile and contact creditors directly on your behalf for debt forgiveness. Debt relief programs will usually request that you stop payments on your monthly credit bills in order to increase the likelihood that a creditor will settle.

Credit Counseling

A nonprofit credit counselor, such as one you may find through the National Foundation for Credit Counseling, can help you identify an appropriate debt management program for your situation.

A credit counselor can help you establish a debt management plan. This structured agreement will allow you to make regular payments toward your unsecured debt that are more manageable for your budget.

Bankruptcy

In some situations, bankruptcy may be the best (or only) option for a borrower. There are several types of bankruptcy, with Chapter 7 and Chapter 13 being the most common ones for individuals.

Chapter 7 involves the sell-off, or liquidation, of the borrower’s assets to help pay their creditors, at least partially. In Chapter 13, the borrower may keep some assets but must agree to a plan for paying off their creditors under court supervision.

How Canceled Debts Are Taxed

The IRS generally counts canceled debt as taxable income. You should receive a Form 1099-C from the creditor if the canceled debt amount is $600 or more.

However, there are quite a few exceptions. According to the IRS, the following are not considered cancellation of debt income:

1. Debts canceled as gifts or inheritance
2. Some qualified student loans that meet specific criteria
3. Other education loans or relief programs that help provide health services
4. Canceled debt that would be deductible if an individual paid it as a cash-basis taxpayer
5. A qualified purchase price reduction on a property provided by the seller
6. Pay-for-Performance Success payments that reduce the principal balance of a mortgage under the Home Affordable Modification Program
7. Amounts of student loans discharged upon the death or disability of the student

In addition, the following are considered cancellation of debt income, but the IRS excludes them from needing to be reported as income:

1. Canceled debt from a Title 11 bankruptcy case
2. Canceled debt to the extent insolvent
3. Cancellation of qualified farm indebtedness
4. Cancellation of qualified real property business indebtedness
5. Cancellation of qualified principal residence indebtedness

The Bottom Line

If you are facing serious financial difficulties, you may be able to get all or a portion of your debts canceled. However, debt cancellation can have long-term negative consequences to your credit, and you should consider it only when there are no better alternatives for you.

Weigh the pros and cons of all your options for addressing your debt, perhaps with the help of a financial advisor.