Tax Advice

Ask a Tax Preparer: Will I Have to Pay Taxes on Forgiven Debt?

Over on our discussion board, an interesting question arose concerning two popular subjects: student loans and taxes.

See, there’s a group of people out there who know that student loan debts can be forgiven. This may be news to most of you, who’ve probably heard that student loans can never be forgiven even in cases of bankruptcy. And although that’s mostly true, for a small group of select borrowers (we outline who they are below), they can be forgiven.

This led folks on our discussion board to pose the following query: Would they be taxed on the amount of debt that was forgiven?

After all, if $30,000 of their loans is forgiven, then the taxes on that could be sizable. Whether or not forgiven debt is taxed also applies to people in other situations, such as those who’ve had the value of their mortgage written down by a lender.

To find out the answer, we spoke with Chris Arotin, an enrolled agent with the I.R.S. But before we address the exact question, it’s important to note that people who file for bankruptcy (i.e. for credit card debt, not student loans) don’t have to pay taxes on the forgiven amount and this is unlikely to change. So, if you’re in that boat, you can breathe a sigh of relief. Now, onto the answer …

Mortgage Forgiveness

We’ll tackle the mortgage situation first because it’s a bit easier. Let’s say that you purchased a home for $450,000, and post housing crisis, it’s now only worth $250,000. The bank does some restructuring, and you only owe the $250,000 that it’s worth. What would normally happen is that the I.R.S. would then treat it as if you had $200,000 extra dollars in earned income and it would tax you on that amount.

But for the years 2007 to 2012, there was a law in effect called the Mortgage Forgiveness Debt Relief Act. “According to this debt relief act, the amount that the bank forgave doesn’t count for tax purposes,” says Arotin. Well, up to a limit. For a single person or for a married person filing separately, the I.R.S. will not tax up to $1 million of forgiven debt, and for a married couple filing jointly, it won’t tax up to $2 million of forgiven debt.

This also applies to other situations in which your debt is written down, such as a short sale. (This is when you, say, buy a house for $450,000, sell it for $250,000 before paying off your debt and the lender forgives the remainder.)

While this law was still in effect for the 2012 tax year, starting in 2013, the I.R.S. will not be refraining from taxing this type of forgiven debt, so if you get the value of your mortgage written down this year, be prepared for a hefty tax bill.

Forgiven Student Loans

Situations in which student loans can be forgiven are rare. The most common way is through the Public Service Loan Forgiveness Program, which will forgive debt that remains after 120 payments for people who are employed full-time by certain public service employers.

“Most of these loans are structured in a way where the borrower has to work a certain amount of time in the given field,” says Arotin. “So be proactive and inquire about forgiveness while you’re going through the student loan process by asking if the program qualifies for one of the provisions.”

In order for your forgiven loan amount to not be taxed, the loan must have been made by:

  1. The federal, state or local government. If, say, the University of Tulsa gave you a loan, this doesn’t apply to you.
  2. A tax-exempt public benefit corporation that has control of a state, county or municipal hospital whose employees are considered public employees.
  3. A school that administered loans from the institutions described above or that has a program encouraging students to work in underserved occupations. Most of these loans are structured in a way that requires the student to work for a certain amount of time in that field, so borrowers will likely find out their requirements”i.e. how long they have to work in that field before the loan will be forgiven when taking out the loan.

One caveat: While many people think that their loans are federal loans, the law distinguishes between loan money that actually came from the government versus from a private lender. Only government loans are eligible for forgiveness.

For more information, check out the student loans section of I.R.S. Publication 4681, which describes tax treatment of canceled debts and foreclosures.