A creditor can forgive or cancel consumer debt. This most often occurs in situations where the debtor is unable to pay a portion of the debt or the entire debt for a variety of reasons, such as unemployment or excessive debt. Once a creditor forgives or cancels a debt, the creditor is prohibited from attempting to collect the forgiven debt from the debtor.
Consumer debt includes money owed for personal credit card debt, medical bills, household items, an auto loan or a mortgage. Consumer debt collection activities are governed by the Fair Debt Collections Practices Act (FDCPA). A creditor of consumer debt can contact a debtor and try to collect the debt, but the law prohibits the creditor from harassing debtors, using false statements, engaging in unfair practices, calling a debtor at work after being instructed in writing or orally not to do so or giving false information to a credit reporting agency.
A canceled debt is a debt that a creditor forgives or cancels. This occurs when a lender agrees to forgive an entire debt or a portion of the debt owed by a debtor. For example, in exchange for a lump sum amount that is less than the outstanding balance, a creditor may forgive the remaining amount of the debt. If canceled, however, this arrangement -- normally referred to as a “charge-off” -- will show up on the debtor’s credit report. A credit reporting agency may continue to list it for up to seven years.
Once a creditor cancels or forgives a debt, the creditor is prohibited from trying to collect the debt. This is because the debt no longer exists, and the debtor therefore no longer has a legal responsibility to pay it. A creditor that continues to make collection attempts on a forgiven debt is in violation of the FDCPA, which prohibits creditors from engaging in collection activities that are deceptive or unfair. A consumer may report this violation to the Federal Trade Commission.
Canceled Debt & Taxes
The IRS considers canceled debt as income. Consequently, the amount of the canceled debt is considered ordinary income subject to taxation. If a creditor cancels consumer debt, and it is not considered a gift or a bequest, the creditor will report the canceled debt as income on Form 1099-C (Cancellation of Debt). Canceled debt is not considered income when it is a qualified student loan or when it is a gift or a bequest. Canceled debt is excluded from gross income when it falls within IRS qualifications for principal residence indebtedness or it is canceled during insolvency.