Cancellation of Debt (COD)

What Is Cancellation of Debt (COD)?

Cancellation of debt (COD) occurs when a creditor relieves a debtor from a debt obligation. Debtors may be able to negotiate with a creditor directly for debt forgiveness. They can also receive debt cancellation through a debt relief program or by filing for bankruptcy. Debts forgiven by a creditor are taxable as income. Canceled debt will typically be recorded by the creditor and reported to a debtor as income on a 1099-C.

Understanding Cancellation of Debt

Distressed borrowers can work directly with a creditor to negotiate debt relief. Many distressed borrowers may choose to file for bankruptcy or work with a debt relief program which can lower a borrower’s total debt.

The main impact of cancellation of debt is the legal requirement to pay taxes on the amount that has been forgiven, as the Internal Revenue Service (IRS) counts this canceled amount as income. When obtaining debt relief borrowers should plan ahead for taxes on potential savings expected from the cancellation of debt.

Individuals will have to file Form 1099-C if the canceled debt amount is $600 or more. In 2018, the IRS received more than 3.9 million 1099-Cs, with expected amounts for 2019 to be 4.3 million and for 2020, 4.4 million.

The cancellation of debt can greatly help provide relief to a distressed borrower. In some cases, debt forgiveness may also be offered between countries for economic support.

Exceptions to Cancellation of Debt

There are quite a few exceptions when it comes to the cancellation of debt income. Defined by the IRS, the following are not considered cancellation of debt income:

1. Debts canceled as gifts or inheritance
2. Some qualified student loans that meet specific criteria
3. Other education loans or relief programs that help provide health services
4. Canceled debt that would be deductible if an individual as a cash basis taxpayer, paid it
5. A qualified purchase price reduction on a property provided by the seller
6. Pay-For-Performance Success payments that reduce the principal balance of a mortgage under the Home Affordable Modification Program
7. Amounts of student loans discharged upon the death or disability of the student

The following exclusions are considered cancellation of debt income but the IRS excludes them from being reported as income.

1. Canceled debt from a Title 11 bankruptcy case
2. Canceled debt to the extent insolvent
3. Cancellation of qualified farm indebtedness
4. Cancellation of qualified real property business indebtedness
5. Cancellation of qualified principal residence indebtedness

Methods of Cancelling Debt

Negotiating With Creditors

Negotiating the cancellation of debt with a creditor can be challenging. Most creditors are not willing to cancel individual debts as interest and fees on approved credit is the main source of income influencing their bottom line. However, some creditors do include provisions in their credit agreements for canceled debt. Many creditors also have credit relief services which can be obtained for a small additional fee and used in specific hardship situations such as a job loss or a medical occurrence. Reviewing the credit card terms of all creditors can help a borrower to identify on their own any creditors that they may easily qualify for debt cancellation from.

Certain loans issued under government programs may have a higher chance of debt forgiveness. These loans may include student loans or mortgage loans eligible for debt forgiveness under government-sponsored relief programs. For distressed borrowers, some lenders may also be willing to negotiate principal reductions on mortgage loans since it could save them some of the costs of a foreclosure.

Debt Relief Programs

Debt relief and settlement companies are available across the nation to help with debt forgiveness. Working with a credit counseling resource such as the National Foundation for Credit Counselors can help a borrower identify an appropriate program for their situation.

Debt settlement companies are for-profit entities that work on behalf of a borrower to negotiate a debt settlement with creditors. There are numerous caveats to working with these companies and the process for settlement can take years. However, debt settlement can be an option for borrowers who have been steadily delinquent in payments.

Debt settlement companies will assess a borrower’s entire credit profile and contact creditors directly on a borrower’s behalf for debt forgiveness. Debt relief programs will usually request that borrowers stop payments on their monthly credit bills in order to increase the likelihood that a creditor will settle. Generally, most companies will also require clients to make monthly escrow payments toward a lump sum settlement which would be paid at some time in the future.

Bankruptcy

In many situations, bankruptcy may be the best option for a distressed borrower. In bankruptcy, the borrower has the support of an attorney and the courts. Debt forgiveness is also not considered income in bankruptcy which can help save tax liabilities. Bankruptcy is a complicated process and the impacts can be long-standing. It's worth speaking to accountants and lawyers before heading down this path.