Under state and federal tax laws, a debt that the creditor forgives the debtor generally is considered taxable income for the debtor. The thinking is that having the debt obligation removed is a financial benefit, even though there is no direct increase in income.
However, in some cases, the IRS applies this in ways that seem to many to be insensitive at best. For example, when a college student dies or becomes disabled, federal student loan suppliers, along with private lenders, often forgive the student’s loans. This can take years of effort by the family, but can seem like a great financial relief once achieved.
But the IRS taxes the amount of the forgiven loans, often creating hefty tax bills for grieving families. In 2014, the average graduating student had just under $30,000 in student loan debt, The News Journal reports.
A bill in the U.S. Senate would exclude the discharge of student loans due to the death or disability of the student from the gross income of the student or his or her survivors. Its sponsor, Sen. Chris Coons of Delaware, calls it “a common sense bill.”
Ironically, while researching the idea, Coons learned that the family of a member of his staff experienced exactly the situation the bill would prevent. The staff member’s brother died in November 2009 of a brain tumor, about six months after graduating college.
Devastated, the staffer’s parents had to pay their deceased son’s student loans, because they had co-signed them. Eventually, they found out it was possible to get the loans forgiven. After years of effort, they got the loans cleared — only to find out the IRS was going to tax them for that “income.”
“They were blind-sided — they had no idea,” Coons’ staff member said.
Stories like this might go away in the future. But in general, financial decisions you make now could have unexpected tax consequences in the future. If you find yourself facing an audit, speak to a tax attorney about what to do next.