Debt Forgiveness

What is debt forgiveness?

Debt forgiveness happens when a lender forgives either all or some of a borrower’s outstanding balance on their loan or credit account. For a creditor to erase a portion of the debt or the entirety of debt owed, typically the borrower must qualify for a special program.

Debt can often feel like a burden. It takes resources away from other areas of need (and yes, you do need to have fun and relax sometimes) and suppresses our ability to save money for big picture goals. Even if you can technically afford your debts, you'd probably rather not have them. And if you can't afford your debts, then you may be looking for some sort of lifeline - a way to take the debts away without having to pay.

In other words, the idea of having your debts forgiven by your creditors is an appealing one. And debts are sometimes forgiven, but there are often costs associated with debt forgiveness. This is what you need to know about debt forgiveness, including when you might qualify and why debt forgiveness is rarely ever free.

How Does Debt Forgiveness Work?

Debt forgiveness happens when a creditor releases you from your responsibility to repay all or some amount of a debt. As a result, you no longer have to worry about repaying the "forgiven" debt.

Debt forgiveness can come in many forms. If you have an account in collections, you may attempt to negotiate with the collector by offering to pay a portion of the debt in exchange for having the remaining debt forgiven. As an example, let's see you owe $10,000 on a charged off credit card account. You ultimately agree to settle the debt for $5,000, with the remaining $5,000 being forgiven.

If you foreclose on your home, or are forced into a short sale where the sales price doesn't cover the remaining mortgage, the lender may forgive all or a portion of the remaining debt.

On certain federal student loans, if you’ve made the required payments over a set period of time (usually between 10 and 30 years), whatever is left of your remaining balance may be forgiven.

Essentially, in any scenario where you owe money and don’t eventually make a full repayment, part or all of the remaining balance may be considered forgiven debt. Nearly any debt could potentially be forgiven (or at least partially forgiven), but whether or not that happens is almost entirely up to the lender or whoever owns the debt. Forgiveness needs to be in their interests, as well, so if you're perfectly capable of repaying a debt in full, there's little chance of a lender offering to forgive any portion of the debt in question.

What does debt forgiveness cost you?

Because debt forgiveness is most commonly connected to settlement, there are two major costs to consider: the cost of the settlement itself (that is, the portion of the debt you do pay), and the tax you pay on the forgiven debt. If you're using a third party to negotiate your settlement, there will be additional costs and fees associated.

As for the settlement amount itself, it will vary, but typically falls around 35-50% of the original debt amount. And if you're using a settlement company, they typically charge 15-25% of the total debt (though some charge based on what you saved, and others may use totally different pricing methods).

So, using the $10,000 example again, in order to get out of the debt, you'll likely need to pay the creditor between $3,500 and $5,000, while paying the settlement company $1,500 to $2,500. Using the low end, we'll say you started with $10,000 in debt, spent $5,000 (including settlement company fees) and had $6,500 forgiven. Not free by any measure, but at least you're out of debt and saved $5,000 in the process.

However, just because you’re square with your creditors doesn’t mean you’re square with the government. Forgiven debt is almost always considered taxable income.

"How can debt be income?" you may ask. Well, I suppose you have to look at it this way – you were provided with money, goods, or services in the amount of your debt. In the above example, from a tax perspective you got a free $6,500. But of course, nothing is actually free, so now you need to pay taxes on that $6,500.

Any time a creditor forgives a debt in excess of $600 they are required to send you a 1099 form reflecting the amount of the forgiven debt, which you must then add to the “Other Income” section of your personal tax return for that year. It should be noted that creditors are required to send you this form because they themselves are claiming your forgiven debt as lost income. If you have a forgiven debt that’s less than $600 you still need to claim it on your taxes – creditors just aren’t required to send notification in that instance.

The impact on your tax return could be major or minor, depending on a lot of factors, such as your income bracket and the amount of the forgiven debt. If you have questions or concerns about how to complete your tax return, be sure to speak with a qualified tax professional.

Exceptions to the rule

You should generally assume that if your debt is being forgiven, you are going to have to pay taxes on the balance. But there are definitely exceptions to that rule.

Your forgiven debt might not be taxable if:

It's a result of a personal bankruptcy

All debts discharged through bankruptcy are generally not taxable.

You are insolvent in an amount greater than the forgiven debt

Insolvency is when your debts outweigh your assets. If you currently owed $10,000 more in debt than you held in assets, and then had a creditor forgive $3,000 in debt, you would not have to claim that $3,000 as additional income. If they forgave $11,000 in debt, however, you would have to claim $1,000 as income.

You completed the terms of a career-specific student loan repayment plan

If you made all of the required payments on a public service loan forgiveness, teacher loan forgiveness, law school loan repayment assistance, or National Health Service Corps Loan Repayment program your forgiven debt is not considered taxable. Any forgiven debt resulting from any other student loan repayment plans, however, including income-based and income-contingent plans, is taxable.

There are a few other unique exceptions, including exceptions for student loans that were discharged due to the death or permanent disability of the student, but those relatively rare. Again, if you have specific questions about how debt forgiveness may impact your personal tax return, please contact a tax specialist. It’s what they do.

In almost every case, the benefit of a forgiven debt far outweighs the tax consequences, but it’s important to be aware of those consequences and plan accordingly. Free money almost always costs you something in the end.

Types of debt forgiveness

How debt forgiveness works can vary depending on what type of debt you’re looking to get forgiven. Here are a few of the more common forms of debt that may qualify for debt forgiveness, as well as some debts that typically don’t.

Student loan debt

Generally, when someone references student loan relief, they are referring to a conglomerate of student loan debt forgiveness programss designed to eliminate part or all of a borrower’s student loan debt. Typically, each program has its own unique requirements and approval standards and there are programs designed to fill specific niches. For example, some professions like nursing and teaching have more options for student loan forgiveness.

Once federal student loan debt is forgiven (private student loan debt forgiveness programs can be difficult to find), the borrower won’t be required to make student loan payments in the future. Eliminating debt may sound like a guaranteed win, but there are pros and cons to student loan debt forgiveness:

Pros

There are a variety of programs that make student loan forgiveness widely available.
Certain professions (such as nursing or teaching) have a leg up and may qualify for a specialized program.
Even if you can’t get all of your debt wiped away, you can likely get some of it forgiven.
You can save money on student loan payments in the long run.
You can get out of debt faster.

Cons

In some cases, student loan forgiveness is a taxable event. Income-driven plans are an example of when you may find a tax bill on your hands post-forgiveness. This is because, under some programs, forgiven loan amounts are viewed as taxable income.
There are plenty of debt relief scams targeting people with student loan debt, which can make it hard to know if you’re actually going to get debt relief.
Private student loans generally aren’t eligible for forgiveness as most forgiveness programs are backed by the federal government and intended for federal student loans.
Forgiveness generally doesn’t happen overnight, and each program varies in length. In some cases, you may need to wait over a decade to qualify for forgiveness. If the time frame is too long, it may be more beneficial to just pay off your debt as quickly as possible so you don’t have to worry about monthly payments any longer.

If you have already defaulted on your federal student loans, you not only lose all federal protections and benefits, but you won’t qualify for forgiveness.

Medical debt

Medical bills can mount quickly and many people struggle to pay for them. Because so many people face medical debt-related challenges, there are processes in place for getting help with this type of debt in the form of medical bill debt forgiveness programs. You can call the hospital where you incurred your debt and ask to learn more about qualifying for the hospital’s “financial assistance policy.” Some hospitals may call this “charity care” and these programs typically look at income when deciding who qualifies. In some cases, the hospital may lower your bill significantly or forgive it completely. Nonprofit hospitals are actually legally required to have assistance policies.

In March, the three major credit bureaus announced that paid medical collections are set to disappear from Equifax, Experian and TransUnion credit reports as of July 1, 2022. These are significant changes that will impact many Americans who are faced with unexpected medical debts that would normally remain on their credit reports for up to seven years. Additionally, unpaid medical collections will not appear on credit reports unless they’ve been in collections for at least a year, and starting next year, medical debts under $500 will no longer appear on credit reports.

Pros

Even if you don’t qualify for complete forgiveness, financial assistance may be available.
There is no set limit for how much you need to earn and often, medical debt forgiveness is awarded on a sliding scale. This means if your income doesn’t qualify for full forgiveness, you can still qualify for partial forgiveness.
If you don’t qualify for forgiveness at all, there are other options for reducing medical debt. For example, if you offer to pay a smaller amount than what is due but do so in one lump sum, you may be able to get your bill reduced.

Cons

It can take a bit of work to get medical debt forgiven and there’s no guarantee that you’ll get the desired end result.
You may need to provide the medical institution with documentation like tax returns and pay stubs to prove the need.

Tax debt

If you don’t have enough money to pay your taxes, you may find you have tax debt and can qualify for an IRS debt forgiveness program. The IRS has a few options to help make repaying that debt more manageable. One of these options, known as “offer in compromise” (OIC), occurs when you owe more than you can afford to pay.

To qualify for OIC, you’ll need to prove that paying that bill will be detrimental to your finances and if approved, you may be allowed to settle your debt for less than you owe. This is usually only an option if you’ve exhausted all other payment choices. The IRS takes your income, expenses, asset equity and ability to pay into consideration. If the IRS believes you can actually pay off your debt, whether in full or in installments, then you won’t qualify for an OIC.

Pros

An OIC allows you to settle your debt for less than you owe, saving you stress and money.
If you don’t qualify for OIC, the IRS offers installment agreements that allow you to make small, manageable payments until your debt is paid off.

Cons

Tax debt relief scams abound. Anyone who guarantees reduced or eliminated IRS debt, especially without actually reviewing your financial situation, is likely running a scam. It’s always best to work directly with the IRS.

Mortgage debt

Unfortunately, mortgage debt forgiveness is pretty hard to come across these days. This is partly because the housing crisis led to lenders having to forgive too much housing debt, and they don’t want to end up in a similar situation again. That being said, mortgage forgiveness can happen. It’s just very unlikely.

Because mortgage loans are secured with collateral in the form of your home, it’s more likely that you will be able to receive a mortgage modification from the lender. A mortgage modification occurs when your lender agrees to alter your original loan so that it is more manageable under your current financial situation.

Pros

While full forgiveness might not be an option, mortgage modification can make your monthly payments much more manageable.
A mortgage modification can even lower the amount of principal that you owe.
Plenty of conventional lenders offer modification and this can be available for FHA-issued mortgages as well.

Cons

Complete mortgage forgiveness is rare and hard to qualify for.

Credit card debt

Credit cards are another example of a type of debt that generally doesn’t have forgiveness options. Credit card debt forgiveness is unlikely as credit card issuers tend to expect you to repay the money you borrow, and if you don’t repay that money, your debt can end up in collections.

Debt settlement is the closest alternative to forgiveness for credit card debt. Credit card debt settlement is a process in which you agree with your lender to pay less than what you currently owe them. It can be wise to try to tackle these negotiations on your own and avoid debt settlement firms. When working with a debt settlement firm, you typically end up owing your payments to the firm instead of the lender.

Pros

Debt settlement can lower your monthly payments and make debt easier to pay down.
You may be able to agree to pay them a lump sum that is less than what you owe in exchange for stopping payments.

Cons

Debt settlement companies are often predatory and your credit score can end up damaged due to their actions. Not to mention, they can charge hefty fees.
Working with a lender directly to settle your debt is a better alternative. But by the time a lender is likely to consider this option, the odds are your payments will be overdue and your credit score will already have taken a hit.

Benefits of debt forgiveness

While the main benefit of debt forgiveness is pretty straightforward (you have less debt to pay), there are a few other benefits worth considering.

Your credit score isn’t impacted

Not being able to pay off your debt can lead to credit score damage due to late or missed payments. When your debt is forgiven, your credit score is generally not affected. Having less debt can also improve your credit utilization which helps boost your credit score.

Lenders won’t come after you

Once your debt is forgiven, you aren’t responsible for the amount forgiven, whether it was for the full amount of debt or just part of it. This means you won’t have to worry about a lender coming after you to collect the debt down the line.

Downsides of debt forgiveness

Debt forgiveness isn’t a perfect process, and the major downside associated with debt forgiveness may outweigh the perks. It will be up to you to decide if it’s worth it or not.

Taxes

Debt forgiveness does not magically wipe away all financial responsibility. Once a debt is forgiven, the forgiven amount is treated as taxable income. The IRS takes most forms of forgiven debt under consideration.

If your forgiven debt amounts to more than $600 and is determined to be taxable, then your lender is required to issue you a 1099-C form that includes the canceled amount you should report. If your forgiven debt amounts to less than $600, then you may not receive a 1099-C. Even without this form, you’ll have to report it on your next tax return.

If you have a lot of forgiven debt, you may find you have a very large tax bill on your hands.

Shady debt settlement agencies

There are a lot of shady agencies ready to prey on people in crisis. Some debt settlement agencies charge money to handle tasks you could have done on your own (such as contacting a credit card issuer’s hardship department). Others are outright scams that take your money without working toward reducing your debt. Do your due diligence before signing up with any debt settlement, credit card consolidation or credit repair program: Consult the Better Business Bureau, look for user reviews, and avoid any program that charges fees upfront.

What should I know before considering debt forgiveness?

Again … if a potential solution to solving debt problems sounds too good to be true, it probably is.

Some companies promise to help you avoid or reduce your debt payments — for a fee, of course. Before signing documents from or sending money to a third party, check the company’s rating with the Better Business Bureau.

Be prepared to walk away if anything smells fishy. Any organization you work with should be able to provide you with clear, time-bound outcomes, and explain how all your costs will add up over the total duration of your repayment — and all in writing.

Take a little time to weigh the other pros and cons, too. Can you afford to pay taxes on any debt that’s forgiven or discharged? If you’re setting up a repayment plan or a settlement plan, how long will it take to reach a payoff date and will the extra costs, like additional interest, be manageable? Make sure to crunch the numbers and find the option that’s most financially beneficial.

Bottom line

If you feel like you’ll never be able to repay all the debts you owe, resist the temptation to bury your head in the sand. Ignoring your bills won’t make them go away, but developing a plan may give you hope and a fighting chance.

Start by reaching out to your creditors to discuss the debt forgiveness or repayment plans available to you. A nonprofit credit counselor may also help you carefully and objectively explore your various options, including bankruptcy.

There may not be a quick fix, but if you weigh the benefits against the costs, you may just come up with a plan for managing your debts that really works for you.