How Does Debt Forgiveness Work?

Drowning in debt might be one of the most stressful predicaments you can experience in your life. Aside from the inability to pay, creditors will be pressuring you to pay your due obligations. This situation is not a pleasant one. How can one prevent or recover from insolvency? Perhaps, you’ve heard of the term “debt forgiveness.”

At first glance, it sounds good. Of course, being forgiven for your debts is a big relief for the debtor. But, is it the best solution? If debt forgiveness is indeed the only or best way out, why do not more people use this remedy? Or if someone used debt forgiveness, did it work to their advantage?

In this article, you’ll learn more about debt forgiveness. We’ll also explore the details about this remedy. And we’ll answer the question, “how does it work?”.

Overview of the Process

A debt forgiveness agreement process is easy in theory, but challenging when applied in real life. It’s not easy to accomplish since creditors would want to collect what’s due to them. However, debt forgiveness works as long as the circumstances are meritorious. Here’s the overview of the process:

  1. Send a letter of request for debt forgiveness addressed to the creditor. Check out the sample template here.
  2. Negotiate with the creditor regarding the debt forgiveness.
  3. Finalize the debt waiver agreement.
  4. Notarize (signed by a notary public) the document.

What Is Debt Forgiveness?

Debt forgiveness is the creditor’s voluntary act to release the debtor from obligation to pay the latter’s debt. When someone forgives your debt, that someone must signify their intention and action to forgive your debt. As a general rule, you can never assume or imply debt forgiveness and definitely when anything agreed is only verbal. 

For formality’s sake, debt forgiveness often comes with an agreement wherein the creditor and debtor agree to condone the debt. Debt forgiveness is a gratuitous contract (a contract benefitting only one of the parties) and is done out of the generosity of the creditor. In the next section, you’ll see how debt forgiveness affects you and the creditor.

How Does It Work: Step-by-Step Guide

STEP 1: Send a letter to the creditor

The letter that you need to send to the creditor is a letter of request for debt forgiveness. Mainly, you’ll tell the creditor to cancel your debt. However, you must provide a reason why you need debt forgiveness. Below are some possible reasons with its corresponding proof:

  1. Lingering medical conditions making you unable to sustain employment – attach a medical certificate signed by your physician along other medical records like tests or body scans.
  2. Mental incapacity (e.g., insanity) or mental illnesses (e.g., depression, anxiety) making gainful employment difficult or impossible – attach a medical certificate signed by a psychiatrist.
  3. Financial incapacity – attach proof of income (e.g., payslips) and expenses (e.g., bills, dues) showing that your monthly income barely sustains your needs or an affidavit stating your financial situation.

STEP 2: Negotiate the terms of the debt waiver

The creditor will surely contact you to discuss the matter. If this is a personal loan, expect the creditor to contact you personally. If not, a representative of the company will reach out to you. Assuming the creditor considers debt forgiveness, always be open to what they have to say. If this debt is of substantial amount, consider bringing a lawyer with you to keep everything within legal confines.

STEP 3: Finalize the debt waiver by execution of an agreement

Once the creditor agrees to the total cancellation of the debt, there must be a debt waiver agreement signed by both parties. The basic information included in this agreement are, but not limited to, the following:

  1. Names of debtor(s) and creditor(s) or the entities they represent (e.g., company, business, practice of profession).
  2. Amount of the debt.
  3. Amount that the debtor paid prior to debt forgiveness.
  4. Date of execution and effect.
  5. Signature of the parties

Check out this sample debt waiver agreement.

STEP 4: Notarize the document

Notarization (signed by a notary gives the debt agreement more credibility. The notary will ensure that all information in the document is true and reflects the intention of the parties. Moreover, the notary will look for signs of coercion with the signers. In this case, the creditor might’ve coerced you agree to some terms just to grant debt forgiveness. But ultimately, notarization makes the document official and it makes the agreement clear to both parties.

Effects of Debt Forgiveness

Since debt forgiveness releases a party from an obligation to pay the debt, it must be in writing to make the agreement clear to both parties. To make the forgiveness of debt enforceable, the debtor must accept, and such acceptance must be in writing. The debtor’s signature in the debt waiver agreement is construed as express acceptance.

Why does it need to be in writing? It’s because debt forgiveness is a form of donation where the creditor releases the debtor from his obligations as an act of liberality. It is as if the creditor gave the debtor money and expects no repayment from it. 

However, the same case would not apply for debt forgiveness on banks or other establishments. Lawyers will be involved in that matter if the amount of debt is substantial. But, there will be instances when companies will naturally write-off your debt. If you’ve received a debt forgiveness letter before, that means that the company has forgiven your debt voluntarily.

1. Can Creditors Reverse a Debt Waiver?

Sometimes, there will be incidents that will put the debtor in a difficult position. For example, a creditor who already forgave the debtor’s debt comes back to the debtor later to ask for repayment. Or perhaps, a creditor who didn’t collect his dues from the debtor suddenly tries to make a collection after a long time. What shall the debtor do?

In legal concepts, there is a principle called “estoppel.” Estoppel is a legal device that courts use to prevent a person from asserting his right because of his previous actions or statements. In simplest words, the creditor cannot collect your debt anymore if he had forgiven it before. Therefore, it’s irreversible.

2. Statute of Limitations on Collecting Debt Within States

Creditors are only allowed to file a collection lawsuit for a certain period provided by the law. These periods differ per State. The statute of limitations protects debtors from unscrupulous creditors who intentionally collect at a later date to benefit from higher interest charges. However, it also protects creditors from debtors who absconds or escapes to avoid payment of the debt. Check out this website to see the statute of limitation for your state.

3. Tax Implication From Debt Forgiveness

So, let’s say Casey is happy that Lily forgave her debt. But, does that mean that she’s free from any other obligation. Well, the Internal Revenue Service (IRS) is particular about this matter. According to IRS Publication 4681, canceled debt is generally part of your ordinary income. The IRS guidelines require you to report only the canceled portion. Check the examples below:

  • Martha owes Carol $10,000. The two parties agreed that Martha must pay after six months. Come the due date, Martha became insolvent. As a sign of generosity, Carol forgave the loan. Thus, Martha reports the whole amount as part of her ordinary income.
  • John owes Mark $10,000. After three months of payment, John was able to pay only $3,000, and he then became insolvent. To maintain their friendship, Mark decided to forgive John’s debt. In this case, John must report $7,000 as part of his ordinary income.

However, not all canceled debts are included in your gross income. Please refer to  IRS 4681 for the exceptions.

4. Debt Forgiveness And Your Credit Score

When your debt from a commercial lender is forgiven, your credit score will remain intact. Since it is at the creditor’s liberality to release you from obligation, it would NOT affect your credit score. If it’s debt relief, such a thing will impact your credit score. In the next section, you’ll know how debt relief differs from debt forgiveness.

Why Is Debt Forgiveness Different From Debt Relief?

Debt relief is partial forgiveness of a debt. Unlike debt forgiveness, wherein the creditor releases the debtor from payment of the debt thereon. In the case of debt relief, the creditor only eases or relieves the debtor from the burden of payment by:

  • Reducing the principal amount
  • Increasing the payment period (e.g., from 2 years to 4 years)
  • Decreasing the interest rate
  • Waiving the imposition of interest rate
  • Repayment holidays wherein the creditor postpones collecting monthly dues for a certain period so that the debtor can recover.

If you’re not willing to condone the debt wholly, it does not fall within the debt forgiveness definition. Instead, it’s debt relief.

If Debt Forgiveness Releases You From the Obligation To Pay, Why Isn’t It a Common Option?

If you remember, debt forgiveness is an act of liberality and generosity on the creditor’s part. Thus, you must convince the creditor to do such a thing. However, it’s easier said than done. Naturally, creditors would want to recover their money. That’s why more often they would opt for debt relief rather than debt forgiveness. Here’s a quick example:

Dennis is insolvent and has outstanding debt of $5,000 to Jack. Dennis asked Jack to forgive his debt. But, Jack also needed the money back. Instead, Jack expressed that Dennis pays $3,000 instead of the original amount.

If Jack forgives the debt, he gets nothing. That’s like $5,000 down the drain. But with debt relief, Jack loses $2,000 but recovers $3,000. By comparing the two options, the second one appears to be a win-win situation. So, that’s the main reason why debt forgiveness is hard to pull off. It will only work if the creditor is okay with getting nothing. 

Now, put yourself in the shoes of Jack. What option would you prefer? There’s a high chance you’ll prefer relieving $2,000 than forgiving the whole $5,000.

Debt Relief During COVID-19

The COVID-19 pandemic interrupted the daily commercial transactions of people. This pandemic may have created a significant impact on your ability to pay outstanding debt. Debt relief is available under the Coronavirus Aid, Relief, and Economic Security (CARES) Act. 

The CARES Act requires lenders who report to credit bureaus to ease their restrictions and help their clients with their outstanding debt. Experian advises everyone to contact their lenders or financial institutions to avail of the relief programs required by the CARES Act. 

Pros and Cons of Debt Forgiveness

Debt forgiveness is a viable and possible option. However, there are several pros and cons about this option.

Pro #1: Avoids Bankruptcy

When you are unable to pay and file bankruptcy, you’ll have to involve the courts so that you’ll be declared bankrupt. The bankruptcy process is long, tedious, and costly. But with simple debt forgiveness, you and the creditor will not go through a lengthy legal process just to settle a debt.

Pro #2: Release from Obligation To Pay

Condonation of debt wipes out an obligation to pay the loan. In other words, if the creditor forgives your debt, it is as if it was already paid. Thus, you’ll no longer be obliged to pay, and the creditor cannot demand payment anymore.

Con #1: Incurrence of Additional Tax Payments

As stated earlier, any forgiven amount is constituted as income on your part. You have to report that to the IRS if you don’t want any trouble with them. In this scenario, your tax dues will be higher than ordinary.

Con #2: Dependent on Creditor’s Liberality

Debt forgiveness will work if the creditor wholeheartedly grants it. In this case, the creditor must not mind the amount unpaid. But, the odds of that happening is low. Of course, creditors are also people with lives to live and resources to manage. Forgiving debts is not an easy thing to do unless the creditor is rich.

Conclusion: Should You Ask for Debt Forgiveness?

You’ve seen a lot of debt forgiveness examples above. But, should you go for it? In a practical sense, there’s no harm in asking. The major factor that you need to consider here is the creditor’s approval. Personal creditors or commercial lenders may hesitate to forgive a loan with a substantial amount. However, as long as you are true to your intentions, there’s no harm in asking for it.

Overall, debt forgiveness is not a totally adverse option to get away from debt. Just make sure that you’re ready for possible repercussions like additional tax payments and rejection from the creditor, especially in the case of a personal loan from friends or family. It may even damage a personal relationship for good.  If you’ve experienced negotiating for debt forgiveness before, share your experience in the comments section below.

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