On Tuesday, I highlighted three ways that you could get rid of your student loans without paying them. While it may feel great to have that burden behind you, you should be aware that you might not be done with your debt quite yet.
Your lender will likely send you a Form 1099-C Cancellation of debt. That means that the amount forgiven for your loans, or any debt for that matter, may be taxable, and you need to include it as income on your tax return.
This inclusion in your income could create another burdensome debt for those who aren’t prepared to pay the additional tax or don’t know how to get around the additional income. Here’s what you need to know in order to minimize the impact of your debt forgiveness.
Types of Debt that Qualify for an Exception for Including in Your Income
The general rule is that you must include the amount of cancelled debt in your income. However, certain debt cancellations qualify for an exception to being included in your gross income:
- Amounts specifically excluded from income by law such as gifts, bequests, devises or inheritances
- Cancellation of certain qualified student loans
- Canceled debt, that if it were paid by a cash basis taxpayer, would be deductible
- A qualified purchase price reduction given by a seller
- Any Pay-for-Performance Success Payments that reduce the principal balance of your home mortgage under the Home Affordable Modification Program
The exception for student loans includes debt forgiven under the Public Service Loan Forgiveness Program and Education Loan Repayment assistance. However, if the debt was forgiven because of services you performed for an institution or another organization that paid the loans (e.g., Teach for America), you have to add that amount to your return. In addition, loans forgiven based on an income-driven plan or total disability or death are also included in your income.
Types of Debts that Qualify for Exclusion from Income
Even if you find out that your debt doesn’t qualify for an exception from including it in your income, you still may get around the additional tax hit by qualifying for one of the following exclusions:
- Debt canceled in a Title 11 bankruptcy case
- Debt canceled during insolvency
- Cancellation of qualified farm indebtedness
- Cancellation of qualified real property business indebtedness
- Cancellation of qualified principal residence indebtedness
In other words, despite being taxable, if you qualify for one of these exclusions, you still don’t have to include your cancelled debt as income. So any debt cancelled in bankruptcy qualifies. The most common exclusion that I see for clients is debt cancelled on a primary residence or debt cancelled while insolvent (your liabilities are more than your assets).
If one of these exclusions applies to you, you will have to fill out Form 982 Reduction of Tax Attributes Due to Discharge of Indebtedness and check the appropriate exclusion. If you qualify for the insolvency exception, it’s also helpful to fill out the insolvency worksheet in Publication 4681 or that many tax software programs can generate.
Getting debt forgiven or cancelled can be a huge relief. But you should also do what you can to avoid additional tax that may create a new liability for you.