Student Loan Forgiveness: Watch for the Tax Traps

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 — and 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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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? The 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:

• Income-contingent repayment, income-based repayment, and Pay As You Earn guarantees loan forgiveness for the amount still not paid after 20 or 25 years of repayment.
• Chapter 13 bankruptcy can eliminate student loan debt, with proper documentation.
• Your school’s closing either during your enrollment period or shortly after you graduate can eliminate some or all of your federal student loan debt.
• If your school incorrectly claimed your eligibility for a student loan, you can utilize the False Certification Discharge to erase this debt.
• Unpaid refunds related to an early withdrawal from school can be discharged from your total loan amount.
• Total and Permanent Disability absolves you of any remaining student loan debt.
• AmeriCorps VISTA and Peace Corps volunteers can have their Perkins Loans reduced by up to 70 percent for four years of service.

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

• Public service with government or nonprofit organization, after 120 qualifying payments.
• Your Perkins Loan can be cancelled if you work as a teacher in shortage areas; within the U.S. armed forces; as a nurse or medical technician; as a firefighter, law enforcement officer, or public defender; as a Title I eligible school support staff, Head Start worker, special education teacher, early intervention provider, or faculty at tribal schools and colleges.
• Those providing medical care in underserved communities can receive loan forgiveness through the National Health Service Corps Loan Repayment Program.
• Standard non-employment based student loan repayment programs through federal agencies allow for a tax-deduction of your interest payments on student loans.
• The Loan Repayment Assistance Program is available for legal professionals serving high need areas such as government or the public interest sector.

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 upward of $10,000 in taxes on a forgiven $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 people with more debt than they can handle — they simply owe it to a different place.

My mother was lucky. She sought help from an affordable 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 can still be a difficult, complicated process.

First, prepare yourself. If you’re on the cusp of having your student loan forgiven for any reason, your best bet is to seek out a tax professional or CPA who specializes in student loans for direct guidance.

Additionally, 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 current conversation concerning student loans, this is the time to talk about the inequality regarding the tax laws for student loan forgiveness.

While you may have fought long and hard to get your student loans forgiven, remember you aren’t out of the woods yet — prepare accordingly with the help of professional so you can pay off any associated taxes as quickly as possible.

Additional background information for this article was provided by Katie L. Thomas, CPA, of Diamond J Accounting.