Federal student loan borrowers who cannot work due to an illness or injury may have their loans discharged due to total and permanent disability. Borrowers can qualify for this discharge in one of three ways: with doctor certification, Social Security benefits or certification from the Department of Veterans Affairs.
This last scenario recently made headlines when a wounded veteran had $223,000 of federal student loans discharged – and then received a $62,000 tax bill in its place.
How did this happen? It has to do with how the government treats forgiven and discharged student loans.
Forgiveness vs. Discharge
Federal student loans offer a variety of means to eliminate your remaining balance, which is one of the many reasons the Student Loan Ranger recommends them over private student loans. The Public Service Loan Forgiveness program, for instance, gets a lot of positive media coverage for forgiving the remaining balances of nonprofit and public service employees after 10 years.
But federal student loans can be discharged if borrowers suffer unfortunate personal circumstances or when schools improperly handle the loans.
The major difference between forgiveness and discharge is the amount forgiven under federal forgiveness programs like PSLF is considered tax-free. That means you won't have to claim the forgiven amount as taxable income on your federal tax returns. But this isn't the case with discharge programs.
While the Department of Education offers discharge programs to alleviate borrowers' student debt, the Internal Revenue Service sees this discharged amount as taxable income. What are the consequences of this?
Your lender will issue you a 1099-C form indicating the amount of your discharge. This amount is considered income for tax purposes, and you can estimate a tax bill of 25 to 30 percent of the forgiven amount.
If you make $40,000 the year of your discharge and have a $50,000 student loan balance discharged, you can expect a tax bomb of $12,500 just for the discharged amount.
But if you're approved for a TPD discharge, you're deemed unable to work. So how can the IRS expect you to pay such a large tax bill?
The only way to avoid the tax ramification of a student loan discharge is to apply for an insolvency exclusion. For the IRS to consider you insolvent, you need to show that your debts exceeded the value of your assets at the time of the loan discharge. You also need to complete IRS Form 982 to apply for this exclusion.
Keep in mind that if you are eligible for an insolvency exclusion, it may not be for the full amount of your loan discharge. You can estimate the value of the exclusion using the worksheet in IRS Publication 4681.
Anyone who has had his or her student loans canceled due to TPD or other taxable discharges can seek relief with the insolvency exclusion. However, the Student Loan Ranger is not a tax professional and recommends borrowers considering this option to speak with one.
If you're ineligible for an insolvency exclusion or only partially eligible, you are responsible for your IRS bill. The IRS does allow short- and long-term installment plans, though, if you cannot afford to pay your bill immediately, and you can apply for these online or by mail or phone.
A short-term installment plan – up to 120 days – has no associated fees, but fees are assessed on long-term plans, with lower fees for direct-debit plans.
Author: Ashley Norwood