What Happens When Debt Is Charged Off as Bad Debt?

Debt is a financial obligation where one party, the debtor, owes money or resources to another, the creditor, with an agreement for repayment over time, often with interest. When this obligation becomes uncollectible, it enters a phase known as “bad debt,” which has significant implications for both the borrower and the lender.

Understanding Bad Debt

Bad debt refers to money owed to a creditor that is deemed unlikely to be collected. This situation arises when a company or individual determines that a receivable, such as a loan or an outstanding invoice, will not be paid. Various types of debt can fall into this category, including credit card balances, personal loans, business accounts receivable, and medical bills.

A common reason is the debtor experiencing severe financial hardship, such as job loss, unexpected expenses, or bankruptcy. Other reasons include disputes over the quality of goods or services, fraud, or the creditor’s own ineffective collection efforts. For businesses, inadequate credit assessment and overly generous credit terms can also contribute to a higher rate of bad debt.

The Charge-Off Action

When a debt is considered uncollectible, a creditor may take an accounting action called a “charge-off.” This means the creditor removes the debt from its active accounts receivable on its balance sheet, recognizing it as a loss. For revolving credit accounts, such as credit cards, this action typically occurs after 180 days of non-payment, as per regulatory guidelines. Other types of debt, like auto or personal loans, may be charged off after 120 days of missed payments.

A charge-off is an accounting adjustment and not debt forgiveness. The debtor still legally owes the money, and the creditor retains the right to pursue collection. The accounting entry for a charge-off involves debiting a bad debt expense account and crediting the accounts receivable.

Consequences for the Debtor

A charged-off debt negatively impacts the debtor’s financial standing. A primary consequence is a substantial drop in their credit score, as payment history accounts for a large portion (35%) of a FICO score. This derogatory mark remains on the debtor’s credit report for up to seven years from the date of the first missed payment that led to the charge-off. Even if the debt is later paid, the charge-off entry typically remains, though its status may be updated to “paid.”

The legal obligation to repay the debt persists even after it is charged off. Creditors often continue collection efforts, either through their internal departments or by selling the debt to third-party collection agencies. These agencies may pursue the debtor, and in many cases, the original creditor or the debt buyer can file a lawsuit to recover the amount owed. If a lawsuit results in a judgment, it can lead to wage garnishment or liens on property.

There can also be tax implications for the debtor if the charged-off debt is later forgiven or settled for less than the full amount. The IRS generally considers canceled debt of $600 or more as taxable income. This means the debtor may receive a Form 1099-C, “Cancellation of Debt,” and be required to report the forgiven amount on their tax return. However, exceptions exist, such as debt discharged in bankruptcy or when the debtor is insolvent, which may allow for exclusion from taxable income; in such cases, Form 982 may need to be filed.

Consequences for the Creditor

For the creditor, charging off a debt reflects a financial loss. The charged-off amount is recognized as a bad debt expense on the income statement, which reduces the company’s reported net income. This action also reduces the value of accounts receivable on the balance sheet, providing a more accurate picture of collectible assets.

Creditors can often claim charged-off debts as a tax deduction, specifically as a bad debt deduction. This deduction helps offset the financial impact of uncollectible accounts. After a debt is charged off, creditors have several options for recovery. They may continue internal collection efforts, but a common practice is to sell the charged-off debt to a debt buyer. Debt buyers purchase these debts, often at a significant discount, and then attempt to collect from the debtor. This allows the original creditor to recover at least a portion of the uncollectible amount and reduce their operational costs.