What is Cancellation of Debt?

Cancellation of debt occurs when a lender tells a borrower that he or she no longer must repay a loan.

How Does Cancellation of Debt Work?

Let's assume that John Doe borrowed $100,000 from Bank XYZ for a luxury car. In the middle of the five-year loan term, John Doe loses his job and defaults on the loan. After lengthy negotiations, Bank XYZ cancels the remaining $30,000 loan balance, repossesses the car and sends him a Form 1099-C for the $30,000, which requires him to pay income taxes on the canceled debt.

Ultimately, for individuals, a judge usually decides whether to cancel debt. The judge can deny the cancellation if the debtor failed to keep adequate records, failed to adequately explain the loss of any assets, committed a crime, disobeyed court orders or did not seek credit counseling.

Companies often negotiate for debt cancellation with lenders, but they too often do so under bankruptcy.

Why Does Cancellation of Debt Matter?

Cancellation of debt can be a relief for borrowers, but it takes a lot of work to make it happen. Often, it is not a matter of simply refusing to pay. In many cases, borrowers must declare bankruptcy, which can have devastating consequences on the borrower's ability to rent apartments, get jobs and borrow money elsewhere.

Additionally, the IRS typically views canceled debt as income to the borrower. Accordingly, borrowers who get their debts canceled often incur large tax bills if the cancellation occurs outside of bankruptcy.