Answer
In the Name of Allah, Most Gracious, Most Merciful.
All praise and thanks are due to Allah, and peace and blessings be upon His Messenger.
In this fatwa:
It is permissible for you to deduct the loan from the Zakah if the person is unable to pay you because of his financial difficulties. If you do this, you should let him know so that he is comfortable with it. If he does not accept it, then you should not insist on it.
In responding to your question, Sheikh Ahmad Kutty, a senior lecturer and an Islamic scholar at the Islamic Institute of Toronto, Ontario, Canada, states:
Deducting a loan from the Zakah Money
You can deduct the loan from the Zakah if the person is unable to pay you because of his financial difficulties. If you do this, you should let him know so that he is comfortable with it. If he does not accept it, then you should not insist on it.
I have chosen this view based on the prevailing views among scholars on this issue.
Another view on deducting loan from Zakah
The above view, however, is not shared by others – including Abu Hanifah and Ahmad. It is also against the official ruling in the Shafi School.
All agree that one cannot write off loans incurred for buying merchandise, as it would lead to the undesirable incentive of merchants to sell the goods, hoping to write them off as zakah. In this way, the sincere intention of worship is diluted by an element of greed, which is not acceptable.
When looked at the issue from the spirit of Shariah and its higher purposes, the first view seems to be more reasonable. It also appears to be supported by some precedents in the Prophetic traditions.
Who Can Receive Zakah?
The recipients of zakah, as stated in the Quran, are:
{Alms are meant only for the poor, the needy, those who administer them, those whose hearts need winning over, to free slaves and help those in debt, for God’s cause, and travelers in need. God ordains this; God is all-knowing and wise.} (At-Tawbah 9:60)
Helping those in debt by Zakah
One category mentioned above reads, ‘and help those in debt’. Since the person you have loaned cannot pay, there is no reason you cannot deduct the debt he owes from your Zakah.
The objection of the second group against it lies in the facts that Zakah entails transferring the ownership to the recipient. If we will set aside the technicality, we cannot doubt by allowing for the deduction of debt from Zakah we are still complying with the spirit of the law: To help relieve the person from the bondage of debt.
Evidence from the Sunnah
There is also a tradition from the Prophet (peace be upon him). One companion incurred a significant loss in the purchase of harvest, and thus became burdened by the debt, and the Prophet (peace be upon him) ordered the companions to give him charity.”
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Based on these pieces of evidence, according to Al-Hasan al-Basri and `Ata’, Imam Ja`far al-Sadiq, Ibn Hazm, and some scholars of the Shafi school, and others, have preferred this view.
In conclusion, you may deduct the loan he owes you from Zakah if he cannot pay you.
Almighty Allah knows best.
Source: www.askthescholar.com