Further Clarification on the Discharge of Student Loans based on Debt Forgiveness

In my last post about a new bill addressing student loan debt forgiveness, I mentioned that student loan debt that is forgiven may be viewed as taxable income.  I wanted to further clarify my earlier statements.  As with most things, there are exceptions.

Generally speaking, debt that is forgiven is typically viewed as income by the IRS and this means that it will be taxed.  Again, this is a very general rule.  But, there are many exceptions to this rule.  For example, from 2007 to 2014, this general rule did not apply to short sales with mortgage debt that is cancelled or forgiven because of the Mortgage Forgiveness Debt Relief Act.

Similarly, with student loans, the specific area in the code that refers to gross income exclusions for student loans is 26 U.S.C. Sec. 108(f).  In addition, the IRS has a publication available here that states if you work for a 501(c)(3) tax-exempt organization for a certain period of time under certain conditions, then your student loan forgiven debt will be discharged and not viewed as gross income.  Within the publication and within the student loan debt forgiveness programs, there are additional parameters that must be met by the borrower (too long to go into for this post, but I can save it for another post if readers are interested in learning more).  But, in short, there is an exception to student loan debt forgiveness taxability.  Additional information about student loan debt forgiveness is available in this other IRS publication on page 4 available here.

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6 thoughts on “Further Clarification on the Discharge of Student Loans based on Debt Forgiveness

  1. Brian says:

    So basically you’re still on the hook for a potentially outrageous DOI hit if you don’t work for a non-profit or a govt. entity for 10 years or more. This is a going to be a huge problem for this country when all of the recent Dept. of Education sanctioned student loan repayment plans (IBR, ICR, Pay as You Earn, etc.) are subject to debt discharge. Most people in these plans have not satisfied the time requirement for discharge, but it will start happening in the next 5 to 10 years. It’s going to be a nightmare for a lot of people, including myself, because when you have significant student loan debt (and I graduated with $150,000 in law school debt of principal alone because no law school is cheap) and you get in the new payment plans that I mentioned above, you don’t even come close to paying the interest each month. So it builds and builds over 10-20 years and you never really pay any principal. When you get to discharge time, you may end up having hundreds of thousands of dollars discharged, and then the IRS says, “Hey, now you owe us DOI tax, and because it was hundreds of thousands of dollars discharged, we’ll be taxing you at the highest possible tax rate.” And the IRS isn’t too forgiving with their payment plans. This totally frustrates the purpose of the income based repayment plans. What a joke. Way to go Congress. You guys continue to do nothing but pad the wallets of the super rich and corporate interests with policies like these.

    • Sora Kim says:

      Yes, Brian, the definition may be even more narrow than that. Presumably, a majority of people are unaware about this potential issue. Others are hoping that a bill will pass that will address the tax liability problem of student loans. So far, none of the bills have been successful. Even the most recent new bill proposed would only apply to certain IBR repayment plans, but the ICR, pay as you earn, other payment plans would not qualify for the exception and it could still be treated as income by the IRS.
      But, yes, you’ve hit the nail on the head. This will be a big problem.

  2. Jane says:

    I am pretty sure there is also an insolvency exception to the general rule that forgiven debt is taxable. If, the moment before your debt is forgiven, you owe more debt than you have in assets, forgiveness should not be a taxable event. If you are on any kind of income-based repayment plan, it is virtually impossible for you to acquire more assets than you have debt. Sora, do you know if I am correct about this?

    • Sora Kim says:

      Yes, there is an insolvency exception in the Tax Code under 26 U.S.C. Sec. 108(a)(1)(b) in which income is discharged as indebtedness (or not viewed as income and thus ignored by the IRS) if the discharge occurs when the taxpayer is insolvent. Good thinking, Jane!

      So, if a borrower’s student loans are forgiven while insolvent, then the income may theoretically be ignored. But, this is very painful to prove. A borrower would essentially need to go through all their assets and liabilities during the time of the discharge and if they have a positive result then they would not be eligible for insolvency. This is very fact-specific.

      The good thing is that generally tax insolvency is typically recognized by both federal and state tax entities. In Massachusetts, this would be the IRS and the Department of Revenue.

      But, one would also want to consider calculating balance sheet insolvency (list of assets and liabilities as of date of discharge) compared to equity insolvency (ability to pay debts) when thinking about insolvency and whether they qualify.

  3. On Tsang says:

    Very timely information. Thanks, Sora!

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