Praise be to Allah.
It was narrated in al-Saheehayn from ‘Abd-Allah ibn ‘Abbas (may Allah be pleased with them both) that the Messenger of Allah (peace and blessings of Allah be upon him) said to Mu’aadh ibn Jabal, when he sent him to Yemen: “Teach them that Allah has enjoined upon them zakah on their wealth, to be taken from their rich and given to their poor.” The Prophet (peace and blessings of Allah be upon him) explained that zakah is something which is to be taken and given, so on this basis it is not permissible to let off someone who owes you money and count that as zakah, because letting someone off a debt does not involve taking and giving.
Shaykh al-Islam mentioned this issue and said: letting someone off a debt does not relieve one of the obligation of zakah, and there is no scholarly dispute on this matter. But you can give this needy person some of your zakah and he can meet his needs using what you give him as zakah; and Allah will help him to pay off his debt in the future, in sha Allah.
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