Today’s college students often leave school with an overwhelming amount of debt. In some cases, student loans are discharged (also known as being cancelled or forgiven). In other cases, these loans are paid off by an employer. Both actions have tax consequences for the student loan borrowers. We’ll explain the tax implications, but first, let’s cover some necessary background information.
Cancellation of Debt Tax Basics
For federal income tax purposes, the general rule is that a taxpayer’s gross income includes any cancellation of debt (COD) income — unless one of several tax-law exceptions applies. The availability of exceptions (found in Section 108 of the Internal Revenue Code) depends on various factors such as the use of the loan proceeds and the borrower’s financial condition at the time the “COD event” occurs.
Here are some of the exceptions:
- The insolvency exception. Taxpayers can exclude COD income to the extent they are insolvent when the COD event occurs. Taxpayers are insolvent when their liabilities exceed the fair market value of their assets immediately before the COD event.
- The bankruptcy exception. This applies to debts that are discharged in bankruptcy proceedings.
- The public service employment exception. COD income from certain forgiven student loans is excludable. To qualify, the loan document must state that all or part of the student loan debt will be cancelled if the student works for a certain period of time in a specified profession for a specified type of employer. Basically, this is a public service requirement. For example, some teachers who work for five years at a school that serves low-income families may be eligible for forgiveness on up to $17,500 of certain federal loans.
Department of Education Loan Discharge Procedures
There are also some non-tax-law provisions that allow student loan borrowers to exclude COD income when the U.S. Department of Education discharges federal student loans. For this purpose, federal student loans include federal Family Education Loans, federal Perkins Loans and federal Direct Loans. For example:
Read more on... RELIEF FROM STUDENT LOAN DEBT: WHAT ARE THE TAX IMPLICATIONS?