Al-Imam Ibn Bāz said: It is obligatory that you pay Zakat to whoever is deserving. What is legislated for you is that you give to him from that which you have in your possession, provided he is from the people deserving of Zakat.
As for writing off a portion of your debt that is owed to you [by someone] and then counting it as Zakat, then that is not enough and not considered as discharged. That is because Zakat is to give and handover wealth — and is not an act of absolving (or writing-off debts). As for the debt he owes, he should be given more time if he is in financial difficulty until it becomes easy for him to repay. This is because Allah stated:
وَإِنْ كَانَ ذُو عُسْرَةٍ فَنَظِرَةٌ إِلَى مَيْسَرَةٍ
‘And if the debtor is in hard times (has no money), then grant him time till it is easy for him to repay…’ (al-Baqarah: 280)
Regarding Zakat, there is no harm in giving it to him if he is from those entitled to it — if he is poor, he may be given something from the Zakat you have; from the wealth that is with you. But as for cancelling something he owes you and considering it as Zakat, then this is not allowed.
Source: Noorun ‘alad-Darb.
Abu Khadeejah