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Canceled debt may mean big tax bill

If your student loan debt is canceled, even because of disability, expect a bill from the IRS. The agency considers forgiven debt of all kinds taxable income.

By MSN Money Partner Apr 6, 2012 2:28PM

This post is by Gerri Detweiler of Credit.com.

   

When Kim Thompson’s $91,000 student loan balance was canceled because of total disability, she thought she had put at least one of her problems behind her. Instead, she traded it for another: a massive debt to the Internal Revenue Service.

 

Two years ago, Thompson, who lives in New Jersey, was diagnosed with a tumor that eventually led to the removal of most of her small intestine, a pulmonary embolism and 12-hour-a-day IV feeding sessions. She retired from her job on a disability pension in July 2010 and was able to get her federal student loans canceled.

 

There was no mention, however, that the debt would be reported to the IRS as Cancellation of Debt Income.

 

"They didn't tell me it was taxable income," she says. "I had no idea."

 

The IRS considers most types of canceled debt taxable income. Lenders must report cancelled debts of $600 or more to the IRS on a 1099-C form. The IRS estimates some 6.3 million 1099-Cs -- for all types of debts, including student loans, credit cards, mortgages, etc. -- were filed for the 2011 tax year.

 

Not all canceled student loan debt is taxable. If Thompson's debt had been forgiven because she worked in a job that qualified her to have some or all of her debt wiped out (certain medical, teaching or law-enforcement positions, for example) she wouldn't now owe the IRS some $26,000. In addition, she owes $5,000 to the state of New Jersey for cancellation of debt income. (Post continues after video.)

But there is no tax break for student loan debt that has been cancelled due to disability, despite the fact that borrowers who qualify for cancellation are considered totally and permanently disabled, and may never work again. In fact, the Department of the Treasury has specifically said that student loans canceled due to the Death and Disability Discharge (Section 437(a) of the Higher Education Act of 1965) are taxable.

 

Another option, the insolvency exclusion, which requires debtors to be insolvent immediately prior to the discharge, may have allowed her to avoid paying taxes on some or all of the $91,000 of the cancelled debt. Thompson's accountant concluded she did not qualify, though she has some doubt.

 

"The (IRS) forms are incredibly confusing," she notes.

 

As a former social worker with a master's degree, Thompson says she’s not intimidated by government forms. She filled out all her paperwork to file for disability on her own, for example. However, even though she spent hours researching the rules surrounding cancellation of debt income, she found no relief for her situation.

 

She tried calling the IRS for assistance. The first time she called, she says, the IRS representative hung up on her. The second time, she says she waited on hold for more than  an hour and was then told to call back she filed her tax return. She says that ultimately she was warned that if she couldn't pay the amount due, the IRS would put a tax lien on her house and report her to the credit-reporting agencies. (We've reached out to the IRS a number of times on this and other issues relating to the 1099-C, but to date haven't gotten a response.)

 

Thompson isn’t the only one who has been struggling with this issue. A reader, Debbie, recently commented on the Credit.com blog:

I have a friend that got two 1099 C's for cancellation of student loans (federal) due to total disability due to cancer of her husband in Jan 2011.  However, her husband passed away in May 2011…This is just another burden on my friend and I am trying to help her out in all ways possible.  She really freaked since the total of the loans were close to $139,000 and she can’t afford to count that as income.

 And reader T. Long commented on the same story:

I had student loan forgiven around for $75,000. This loan was in 1994. I have not had a full-time job since that time. I received 1099-C from NElNet. What are the ways I can be exempt from this tax other than being insolvent by using form 982? If do have to use form 982 and claim insolvent what type attachments (do) I have send along with 982?

And another reader named Kim commented:

My student loans were discharged. I am on Social Security. Do I have to file the 1099-C I received for $62,000? My student loans were discharged due to total disability and I don’t file taxes because Social Security is non-taxable….HELP!!!!

Thompson, who says she would work if she could, is indignant about a policy that forces disabled borrowers like her to trade one type of debt for another.

 

"There's a reason my student loans were wiped out, and I think they should consider it," she says. "It's just one more thing that I have to worry about."

 

More from Credit.com and MSN Money:


VIDEO ON MSN MONEY

6Comments
Apr 8, 2012 7:48AM
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IRS = legalized blood suckers and grave robbers
Apr 9, 2012 7:21PM
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The IRS has entirely too much power.  They need an agency to over see them. Taxes themselves are out of control. You pay taxes on what you make. Then you pay on what you spend. Then you pay again on what you own.  It NEVER ends.  State and Federal government always exempts themselves of any law where they may not get paid. That's why you can't file bankruptcy on back taxes or child support or student loans etc. They are always looking for ways to tax people and kick them when they are down. America land of the free??? Free to pay taxes.

Apr 9, 2012 7:22PM
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many people may qualify under the insolvency provisions of irc section 108. unfortunately, the bankruptcy reform act during the bush administration gutted most of the protective provisions for individuals. the banking and credit card lobby rammed these provisions through congress. these goons said that people should be responsible for their debts. about 10 years later these same people were getting bailouts of incredible proportions. sort of sad, but this is what happened.
Dec 11, 2012 2:07AM
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After reading this I was quite upset. I was not aware of this. I recently became disabled and I am on social security disability. I applied for my student loans to be forgiven. The application was approved. I came across this article and thought it may help others as it was useful information for me since the only asset I have is my vehicle: My daughter is an accountant so I will be looking into this further.   http://www.nolo.com/legal-encyclopedia/tax-consequences-settled-forgiven-debt-29792.html 
Apr 10, 2012 12:47PM
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Hmm....cancelled debt due to death is taxable.

 

Alright ghosts, make sure you pay your fair share now! Being dead is NO excuse!

Apr 8, 2012 5:31PM
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Incredible! How do they expect the disabled to pay? This is robbery!!!
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