The nation’s student loan debt amounts to $1.3 trillion. Unfortunately, many students finish college with crushing debt without the gainful employment needed to pay off the debt. In some cases, student loans may be discharged or paid off by another party.
When debt is forgiven, the amount forgiven is generally taxable income to the borrower.
Fortunately, there are a few special provisions that help students avoid paying tax on discharged student loans.
Excluding Debt Forgiveness in General
There are two primary provisions that allow taxpayers to exclude debt forgiveness from taxable income:
• When the taxpayer is insolvent (i.e., the taxpayer’s total liabilities exceed her total assets), debt discharge income is excludable to the extent of the taxpayer’s insolvency (see example below)
• When the taxpayer’s debt is discharged through bankruptcy, debt discharge income is fully excluded from taxable income
Example: Joan has $100,000 in student loan debt and is unable to find a job in her profession. The student loan is her total debt and the value of all her assets is $25,000. To determine insolvency, Joan’s total assets ($25,000) are subtracted from her total liabilities ($100,000) and Joan’s insolvency is $75,000. Therefore, Joan can exclude $75,000 from taxable income. She must pay tax on the remaining $25,000 of debt forgiveness.
Example 2: Same facts as above except that Joan’s student loan is forgiven through bankruptcy (incredibly difficult to do). Since the student loan was discharged in bankruptcy, the full $100,000 discharged is not taxable.
Special Provisions for Student Loan Forgiveness
Tax Exclusion if Student Loan is Forgiven When Student Works in Certain Professions
Congress enacted a special rule that excludes student loan debt forgiveness from taxable income if the student works for a certain period of time in certain professions and for any of a broad class of employers. Congress enacted this special rule for certain student loans to encourage students to go into such occupations as medicine, nursing, and teaching in rural and low-income areas.
Department of Education Student Loan Discharges
The Education Department can use at least a couple procedures to discharge federal student loans.
Under the Closed School discharge process, the department can discharge a student loan when the student was attending a school at the time it closed or if the student withdrew within a certain period before the closing date. Student loans discharged under this program are excludable from taxable income.
Under the Defense to Repayment discharge process, the Education Department is required to discharge a federal Direct Loan if a student establishes, as a defense to repayment, that the school’s actions would give rise to a cause of action (lawsuit) against the school under state law. Student loans forgiven under this program are taxable unless the student qualifies under the insolvency or bankruptcy exceptions described above.
In 2015, the IRS ruled that students who took out student loans to finance attendance at a school owned by Corinthian Colleges, Inc. (eg, Everest, Everest University Online, Everest College Phoenix, Heald College, WyoTech) are able to exclude student loan debt forgiveness if the student loan was discharged under either the Closed School discharge process or the Defense to Repayment discharge process. This relief helps students whose student loans were discharged under the Defense to Repayment provision by not requiring them to prove insolvency or file for bankruptcy.
When Student Loans are Paid by an Employer
When an employer pays a student loan for an employee, it is taxable compensation to the employee. Simple enough.
To see how this applies to you, give us a call at 248-538-5331.
Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.