Cancellation of Debt (COD) Definition, How It Works, How to Apply

What Is Cancellation of Debt (COD)?

Cancellation of debt (COD), sometimes referred to simply as debt cancellation, occurs when a creditor relieves a borrower from a debt obligation. Debtors may be able to negotiate with a creditor directly for debt forgiveness. They can also have debts canceled through a debt relief program or by filing for bankruptcy.

Debts forgiven by a creditor are generally considered taxable income. Canceled debt will typically be reported by the creditor to the IRS and to the debtor on a 1099-C form.

How Debt Cancellation Works

Debts may be canceled in a variety of ways, including negotiations between the creditor and debtor, debt relief programs, and personal bankruptcy. Here is a more detailed look at each of those options and their pros and cons:

Negotiating With Creditors

Negotiating a cancellation of debt with a creditor can be challenging because creditors, quite understandably, want the money they are due. However, a creditor may be open to canceling a portion of the debt if the borrower repays the rest of it on the assumption that something is better than nothing. Some creditors also have provisions in their credit agreements for canceled debt.

Many creditors also have credit relief services that are available for a small additional fee and come into play in specific hardship situations such as a job loss or serious illness.

Certain loans issued under government programs may have a higher chance of debt forgiveness. These loans can include federal student loans and mortgage loans eligible for debt forgiveness under government-sponsored relief programs.

In the case of mortgages, some lenders may also be willing to negotiate principal reductions because that can be less expensive for them than initiating a foreclosure.

Debt Relief Programs

Reputable debt relief and settlement companies can also help with debt forgiveness. A credit counseling resource, such as the National Foundation for Credit Counseling, 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 with creditors. Borrowers should make sure that they are dealing with a legitimate one and be aware that the settlement process may take years. However, debt settlement can be an option for borrowers who have been steadily delinquent in payments and see no way of catching up.

Debt settlement companies will assess a borrower's entire credit profile and contact creditors directly on the 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 that will have to be paid at some point in the future.

Bankruptcy

In some situations, bankruptcy may be the best (or only) option for a borrower. There are several types of bankruptcy, with Chapter 7 and Chapter 13 being the most common ones for individuals. Chapter 7 involves the selling off, or liquidation, of the borrower's assets to help pay their creditors, at least partially. In Chapter 13, the borrower may keep some assets but must agree to a plan for paying off their creditors under court supervision.

Bankruptcy can have long-term negative consequences for the consumer and is not to be entered into lightly. For example, a Chapter 7 bankruptcy can remain on an individual's credit report for up to 10 years and a Chapter 13 for up to seven.

How Canceled Debts Are Taxed

The Internal Revenue Service (IRS) generally counts canceled debt as taxable income. Individuals should receive a Form 1099-C from the creditor if the canceled debt amount is $600 or more.

However, there are quite a few exceptions. According to 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

In addition, the following are considered cancellation of debt income, but the IRS excludes them from needing to be 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

The Bottom Line

Borrowers who are facing serious financial difficulties can sometimes get all or a portion of their debts cancelled. However, debt cancellation can have long-term negative consequences for the borrower and should be considered only in situations when there are no better alternatives.