What Happens if a Debt Is Cancelled?

Cancelled debts are usually the result of debt settlement. A debtor unable to pay a delinquent debt in full enters into an agreement to pay a portion of the debt, in exchange for the creditor agreeing to cancel the remaining balance. Settlements occur often in negotiations over defaulted credit card accounts. A debtor with a $15,000 credit card debt may settle for half the amount -- $7,500. That represents a significant savings for the debtor and completely resolves the debt. However, the debtor may face tax liabilities because of the settlement.

Timeline

Creditors will not settle debts that are current because there is no reason for them to cancel a portion of a debt that the debtor is paying as agreed. Creditors usually consider debt settlement offers only when it appears the debtor may default on the loan. Usually, creditors entertain debt settlement discussions when unsecured credit accounts such as credit cards fall at least three months behind.

Process

Either side can request a settlement, but the creditor or debt collector is under no obligation to cooperate. If the creditor does agree to a settlement, both sides agree on terms and the process ends when the debtor makes all payments according to the settlement. Creditors prefer settlement payments in a lump sum, although installments are sometimes possible.

IRS Form

After the settlement, the creditor sends the debtor a form for income tax reporting purposes, if the settlement resulted in savings of at least $600 for the debtor. The Internal Revenue Service treats the savings as income, unless the debtor was financially insolvent at the time. Insolvency means a person has more debts than assets. Creditors send debtors IRS Form 1099-C, Cancellation of Debt. In some cases, debtors may experience higher tax bills because of settlement.

Charge Off

Some debtors may confuse a charge off with a debt cancellation. A charge off is an accounting term creditors use to classify accounts closed for nonpayment. Charge offs are very damaging to credit, with the creditor reporting the information to the major credit bureaus for seven years. However, a charge off does not cancel the debtor's responsibility for paying the debt. Cancellation of a debt is possible only by paying the debt in full, settling for less than the full amount or eliminating the debt through bankruptcy.