If you are one of the lucky few who have qualified for a discharge or cancellation of your student loan debt, you may be shocked to learn the debt may not be over with just yet.
A reader brought to my attention that the forgiveness of student loan debt, even under a disability discharge, can result in the issuance of a 1099-C notification to the Internal Revenue Services and the forgiven debt will have to be reported on your income tax return just as if you earned it. You may then have to pay income tax on that forgiven debt. Yikes!
So What is a Student Loan?
A student loan is defined as “any loan to an individual to assist the individual in attending an educational organization described in § 170(b)(1)(A)(ii) made by (A) the United States, or an instrumentality or agency thereof, (B) a State, territory, or possession of the United States, or the District of Columbia, or any political subdivision thereof, or (C) certain tax-exempt public benefit corporations. The Taxpayer Relief Act of 1997 (1997 Act), Pub. L. 105–34, added § 108(f)(2)(D), which amended and expanded the definition of “student loan” to include loans made by the educational organizations themselves if the loans were made either:
(i) pursuant to an agreement with any entity described in subparagraph (A), (B), or (C) under which the funds from which the loan was made were provided to such educational organization, or
(ii) pursuant to a program of such educational organization which is designed to encourage its students to serve in occupations with unmet needs or in areas with unmet needs and under which the services provided by the students (or former stu- dents) are for or under the direction of a governmental unit or an organization de- scribed in section 501(c)(3) and exempt from tax under section 501(a).
The 1997 Act further amended § 108(f)(2) to provide that the term “student loan” includes any loan made by an educational organization described in section 170(b)(1)(A)(ii) or by an organization exempt from tax under section 501(a) “to refinance a loan to an individual to assist the individual in attending any such educational organization but only if the refinancing loan is pursuant to a program of the refinancing organization which is designed as described in subparagraph (D)(ii).”1 The legislative history to the 1997 Act explains that, in the case of loans made or refinanced by educational organizations (and loans refinanced by certain tax-exempt organizations), the student’s work must fulfill a “public service requirement.” See H.R. Conf. Rep. No. 105–220, at 375–76 (1997).”
Here is how the IRS defines a debt.
A debt is any amount owed to you, including stated principal, stated interest, fees, penalties, administrative costs, and fines. The amount of debt canceled may be all or only part of the total amount owed.
Creditors must report forgiven debt when the debt is cancelled.
- A discharge in bankruptcy under Title 11 of the U.S. Code. For information on certain discharges in bankruptcy not required to be reported, see Exceptions, later.
- A cancellation or extinguishment making the debt unenforceable in a receivership, foreclosure, or similar federal nonbankruptcy or state court proceeding.
- A cancellation or extinguishment when the statute of limitations for collecting the debt expires, or when the statutory period for filing a claim or beginning a deficiency judgment proceeding expires. Expiration of the statute of limitations is an identifiable event only when a debtor’s affirmative statute of limitations defense is upheld in a final judgment or decision of a court and the appeal period has expired.
- A cancellation or extinguishment when the creditor elects foreclosure remedies that by law extinguish or bar the creditor’s right to collect the debt. This event applies to a mortgage lender or holder who is barred by local law from pursuing debt collection after a “power of sale” in the mortgage or deed of trust is exercised.
- A cancellation or extinguishment making the debt unenforceable under a probate or similar proceeding. Enter “E” in Box 6 to report this identifiable event.
- A discharge of indebtedness under an agreement between the creditor and the debtor to cancel the debt at less than full consideration.
- A discharge of indebtedness because of a decision or a defined policy of the creditor to discontinue collection activity and cancel the debt. A creditor’s defined policy can be in writing or an established business practice of the creditor. A creditor’s established practice to stop collection activity and abandon a debt when a particular nonpayment period expires is a defined policy.
- The expiration of non-payment testing period. This applies only to entities described in numbers 1, 2, 3, or 4 under Who Must File, earlier. This event occurs when the creditor has not received a payment on the debt during the testing period. The testing period is a 36-month period ending on December 31, plus any time when the creditor was precluded from collection activity by a stay in bankruptcy or similar bar under state or local law.
- The creditor (or a third party collection agency on behalf of the creditor) has engaged in significant bona fide collection activity during the 12-month period ending on December 31, or
- Facts and circumstances that exist on January 31 following the end of the 36-month period indicate that the debt was not canceled. Significant bona fide collection activity does not include nominal
or ministerial collection action, such as an automated mailing. Facts and circumstances indicating that a debt was not canceled include the existence of a lien relating to the debt (up to the value of the security) or the sale or packaging for sale of the debt by the creditor.
All is Not Lost. Your Best Friend is the 982.
If you are insolvent, meaning your liabilities exceed your income, there is a way to be exempted from any tax that might be due from forgiven debt. And as you can imagine, these tax issues are tough and complex. If you get a 1099-C or have forgiven debt, please talk to a competent tax adviser for specific advice. I’m not that guy.
The IRS has a form 982 which can eliminate tax due following loan forgiveness.
But as you may know by now, the IRS is not the bastion of clarity.
According to the IRS which feels discharged or forgiven student loan debt may be taxable, they also say, “The cancellation of a student loan for a student required to work for certain employer” is an exception to the rule. How that’s defined is uncertain.
Even if you are not completely insolvent, you would only be taxed on the amount of the forgiven debt that took you above being solvent.
So if your liabilities were $25,000 and your assets were $10,000, your liabilities would exceed your assets by $15,000 and you would be insolvent.
If the forgiven student loan was $20,000 it is my understanding that only the amount of the debt that takes you above a break-even point is taxable. In this case only $10,000 of the forgiven debt would result in taxes due.
If you are unable to pay the taxes due you can either make a payment agreement with the IRS or after more than three years the IRS debt can be forgiven in a consumer bankruptcy without any tax liability.
I fully appreciate this can be confusing and mind bending but that’s why I think you should consult with a tax adviser. And if you don’t make a lot of money, you may even be eligible for free tax help through the VITA program.
Just Be Aware
I don’t want you to become alarmed, just informed. Be aware that the discharge of student loans is not the end of the journey to dealing with your student loan debt, there is one more step in the process to deal with.
You are not alone. I'm here to help. There is no need to suffer in silence. We can get through this. Tomorrow can be better than today. Don't give up.
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