December 11, 2012 is a day that I will never forget.

I'd just gotten off the phone with my mother, and we were both in tears. Her permanent disability was approved after a very expensive journey. Now she would receive the financial help she desperately needed to survive – she’d get to shed one of her biggest debts, a $21,000 Direct PLUS loan she had taken out for my college education.

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Student Loans: Watch for the Tax Trap When Seeking Forgiveness

But two months later, when tax season rolled around, her accountant broke some shocking news.

Instead of getting a refund, it turned out she owed $5,000. The culprit? Her student loan forgiveness.

The Reality of Student Loan Forgiveness

There are several ways to achieve student loan forgiveness: you can work for a nonprofit, teach in an approved subject area or school, or have a permanent or temporary disability. However, many people don't realize that while you may have erased the debt, the government treats most versions of forgiveness as a tax liability.

Loan Forgiveness Programs or Events That are Tax-liable:

  • ICR, IBR, PAYE Repayment (forgiveness after 20 or 25 years of repayment)
  • Bankruptcy
  • Closed School
  • False Certification Discharge
  • Unpaid Refund
  • Death
  • Total and Permanent Disability
  • Discharge for Perkins Loans for VISTA and Peace Corps volunteers

Loan Forgiveness Programs or Events That Won't Cost Additional Taxes:

  • Public service
  • Perkins Loan cancellations for teachers in shortage areas, U.S. armed forces, nurses, medical technicians, firefighters, law enforcement officers, public defenders, Title I eligible school support staff, Head Start workers, special education teachers, early intervention providers, and faculty at tribal schools and colleges
  • National Health Service Corps Loan Repayment Program
  • Student loan repayment programs through federal agencies
  • LRAP for workers serving high need areas and law school assistance programs

If you're unsure about your situation, check out the IRS webpage on student loan forgiveness.

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Preparing for the Tax Hit

In the current system, those making near or below the poverty line, the disabled, and the bankrupt often end up footing upwards of $10,000 in taxes on a $40,000 loan. These are people who applied for programs specifically because they couldn’t pay their student loan bill.

While forgiveness does erase a certain amount of untenable debt, it often still leaves them with more debt than they can handle – they simply owe it to a different place.

My mother was lucky. She sought help from a non-profit CPA who walked her through the steps of applying for insolvency. In other words, her assets were less than the amount of the loan before it was forgiven. Proving insolvency is really the only way to get out of the tax bomb, but it's as difficult and complicated as it sounds.

Therefore, there are two things you need to do:

First, prepare yourself. If you're at the cusp of having your student loan forgiven for any reason, your best bet is to seek out a financial advisor who specializes in taxes or student loans for direct guidance. In addition, set up a savings account three to five years in advance to help pay your loan forgiveness bill. That, or push yourself to pay off the remainder before the deadline.

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Second, fight back. There are several legislators working on this issue. And in light of the controversy surrounding student loans, this is the time to talk about the inequality involved in the tax laws for student loan forgiveness.