What Happens When a Loan Is Written Off?

When a financial institution determines a borrower is unlikely to repay a loan, it may initiate a loan write-off. This accounting action has implications for both the lender and the borrower. This guide explores what occurs when a loan is written off.

Understanding Loan Write-Offs

A loan write-off is an internal accounting adjustment made by a lender when a loan is deemed uncollectible. A loan write-off means the lender removes the loan from its active balance sheet, treating it as a loss for reporting purposes. This bookkeeping measure impacts the lender’s financial statements by reducing assets and recognizing a bad debt expense.

Lenders typically write off loans after a prolonged period of non-payment, often when payments are 120 to 180 days overdue. The purpose of a write-off is to clean up the lender’s balance sheet, providing a more accurate picture of its financial health and potentially reducing its tax liability. A loan write-off is distinct from a “loan waive-off,” where the debt is formally forgiven and the borrower is no longer obligated to repay it.

Borrower Consequences

When a loan is written off, the borrower faces significant repercussions, particularly concerning their credit standing and potential tax obligations. While the lender adjusts its internal records, the borrower’s legal obligation to repay the debt generally remains. A write-off does not extinguish the debt; it merely signifies the lender’s internal recognition of the debt as a loss.

A loan write-off, often referred to as a “charge-off” on a credit report, severely impacts the borrower’s credit score. This negative entry remains on credit reports for up to seven years from the date of the first missed payment that led to the charge-off. A charge-off indicates a substantial failure to meet financial obligations, which can make it considerably more difficult to obtain new credit, loans, or even secure housing or employment in the future. Even if the debt is later paid, the “charge-off paid” or “settled” status will still appear on the credit report, though it may have a less negative impact over time.

A consequence for the borrower involves potential tax implications if the written-off debt is later canceled or forgiven. If a lender cancels $600 or more of debt, they are generally required to issue Form 1099-C, Cancellation of Debt, to both the borrower and the IRS. The IRS typically considers canceled debt as taxable income, and the borrower must report this amount on their federal income tax return for the year the cancellation occurred.

However, specific exceptions and exclusions may allow a borrower to avoid paying taxes on canceled debt. For instance, debt canceled in a Title 11 bankruptcy case or to the extent the taxpayer was insolvent immediately before the cancellation may be excluded from income. Insolvency means that a borrower’s total liabilities exceeded the fair market value of their assets at the time the debt was canceled. Other exclusions can include qualified farm indebtedness or qualified principal residence indebtedness discharged before January 1, 2026. To claim an exclusion, borrowers usually need to complete IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to their tax return.

Lender Actions and Outcomes

Even after a loan is written off, the original lender retains the right to pursue collection. A write-off is an internal accounting measure and does not legally absolve the borrower of their obligation. Lenders may continue their own internal collection efforts, contacting the borrower to arrange repayment. These efforts might involve in-house collection departments, attempting to negotiate a payment plan or a settlement for a reduced amount.

A common practice for lenders after writing off a loan is to sell the debt to third-party debt buyers. These debt buyers acquire the defaulted accounts for a small fraction of their face value, typically between 1 cent and 5 cents on the dollar, though this can vary based on the debt’s age and type. Once purchased, the debt buyer assumes the right to collect the full amount from the borrower, often through aggressive tactics. The borrower’s account may then appear twice on their credit report: once from the original creditor and again from the debt buyer or collection agency.

Lenders may also engage third-party collection agencies to pursue the debt on their behalf. Unlike debt buyers who purchase the debt, collection agencies typically work on a contingency basis, earning a percentage of any amounts they successfully collect. These agencies contact the borrower to demand payment, and their actions are regulated by federal and state laws.

If collection attempts are unsuccessful, the lender or the debt buyer may pursue legal action against the borrower to recover the debt. This can involve filing a lawsuit to obtain a court judgment, allowing for more forceful collection methods. Methods can include wage garnishment, where a portion of the borrower’s earnings is legally withheld and sent directly to the creditor. Federal law limits wage garnishment to 25% of disposable earnings or the amount by which weekly disposable earnings exceed 30 times the federal minimum wage, whichever is less.

Similar to wage garnishment, a court order is generally required for a bank levy, though government agencies like the IRS can initiate levies without one. Creditors may also seek property liens, placing a legal claim against the borrower’s real estate or other assets. This can complicate selling or refinancing those assets until the debt is satisfied. From the lender’s perspective, writing off a bad loan also allows them to claim a tax deduction for the loss, which can offset other taxable income.