Debt Forgiveness

Debt forgiveness is a process through which creditors reduce a borrower's outstanding balance on a loan account partially or entirely. Borrowers can negotiate with creditors or file bankruptcy to reduce their debt obligation. Also, one might have to qualify for a certain program to be eligible for debt cancellation.

Usually, the creditor needs to report the canceled amount to the borrower and the IRS Form 1099-C. As a result, the debtor has to pay taxes on the amount of debt forgiven. Moreover, when a lender writes off some or the entire amount due from a borrower, it can severely affect the latter’s credit score.

• Debt forgiveness meaning refers to the total or partial cancellation of a debt owed by individuals or organizations. Borrowers can negotiate with creditors or declare bankruptcy to reduce the debt burden.
• Borrowers may have to fulfill certain eligibility criteria to qualify for loan forgiveness programs. For example, debt forgiveness programs for student loans require borrowers to meet certain conditions concerning income, occupation, etc. 
• When a creditor forgives a debt of more than $600, they must file Form 1099-C and send a copy to the borrower.
• Organizations like veteran groups, churches, funds, etc., offer medical debt relief assistance programs.

Debt forgiveness occurs when a lender releases a borrower from their responsibility to repay some or the entire outstanding amount. Typically, Individuals must negotiate with the creditor to reduce their debt burden. Also, some debt forgiveness programs offer relief to borrowers if they fulfill certain conditions. In case there’s no other option, one can declare bankruptcy. However, one should remember that debt cancellation has significant credit consequences and tax burdens.

After understanding debt forgiveness meaning, one should know its different types. So, let us look at them in detail.

#1 - Student Loan

Federal student loan forgiveness programs are the only way for borrowers to get a lender to relieve them of the responsibility to repay the outstanding balance on a loan account. The Public Service Loan Forgiveness or PSLF program is one such program offering debt forgiveness for student loans. In addition, it forgives eligible debtors’ loans if they work in specific industries for certain durations.

That said, fulfilling the eligibility criteria of such loan relief programs is difficult as it depends on multiple factors such as income, occupation, and the total amount owed. Moreover, one has to make loan payments for a certain duration before the creditor forgives the debt.

#2 - Medical Loan

It is extremely unlikely for borrowers to get medical debt cancellation. That said, debtors can get relief if they qualify for certain assistance programs offered by the government and specialized organizations. Examples of these organizations are as follows:

• Churches and local businesses
• Funds and foundations
• Veteran groups

To fulfill the eligibility criteria of such loan forgiveness programs, one must meet certain conditions based on household size, income, etc. Usually, health care providers and hospitals work with borrowers to reduce their debt. Moreover, debtors may be able to set up a repayment plan or negotiate medical bills.  

#3 - Credit Card

Most companies rarely wipe off a borrower’s entire debt. That said, debtors can opt for certain options such as debt settlement and declaration of bankruptcy to reduce some of the outstanding balance. Nevertheless, one must note that credit card debt forgiveness severely impacts a borrower’s credit score.

Let us look at a few debt forgiveness examples to understand the concept better:

Example #1

President Joe Biden’s student debt forgiveness plan won’t be subject to federal taxation. However, seven states that do not adhere to the nation's nationnational tax policies are likely to impose income tax on the debt forgiven. The states are as follows:

• North Carolina
• Mississippi
• Indiana
• Minnesota
• Arkansas
• California
• Wisconsin

This cancellation plan would forgive debt worth up to $10,000 for individuals with an income below $125,000 and would wipe off $20,000 for Pell Grant recipients in college.

Example #2

Suppose David avails a loan from ABC company. He managed to repay a part of the principal amount and interest over the next five years via monthly installments. However, after that, he lost his job and did not have the necessary funds to repay the entire loan.

David sought debt forgiveness and negotiated with ABC to settle the debt for less than what he originally owed. ABC accepted a lump sum payment and, in exchange, canceled a portion of his debt. Although David did not have to pay the due amount, his credit score dropped significantly.

The amount of debt a creditor forgives is subject to taxation. When creditors forgive debt worth more than $600, they must send Form 1099-C required by the U.S. Internal Revenue Service to the borrower. This form reflects the amount of debt reduced by the creditor. The borrower must add this amount to the ‘Other Income’ section while filing the income tax return for that year.

Creditors must send this form to the borrowers as they claim the forgiven outstanding balance as lost income. If a borrower has a forgiven debt worth less than $600, they still have to claim the amount as lost income. That said, creditors do not have to send a notification to the borrower in this case.   

One must remember that the impact of loan forgiveness on an income tax return depends on multiple factors, for example, the borrower’s income tax bracket, the total amount of borrowings forgiven by the creditor, etc.

This article has been a guide to What is Debt Forgiveness and its meaning. Here we explain its types with examples and discuss whether it is taxable. You can learn more from the following articles -

• Debt Consolidation
• Federal Income Tax
• Debt Settlement