Student Loan Discharge

Recently, the Internal Revenue Service (IRS) issued guidance to certain taxpayers with federal or private student loans acquired to finance attendance at a non-profit or for-profit institution of higher education.  The new guidance (outlined in Revenue Procedure 2020-11) offers relief for students with discharged indebtedness via meeting an established safe harbor.  

Generally, the discharge of debt is a taxable event and treated as income to the borrower.  Under the newly established safe harbor, affected taxpayers will not recognize student loan forgiveness income. 

The safe harbor will apply to any taxpayer whose FEDERAL loans are discharged by the Department of Education based on the following:

• Participation in the Closed School discharge process

The Closed School discharge process allows the Department of Education to discharge a student loan obtained by a student, or by a parent on behalf of a student, who was attending a school at the time it closed or who withdrew from the school just before it closed.

• Participation in the Defense to Repayment discharge process

The Defense to Repayment process allows the Department of Education to discharge a student loan obtained by a student, or by a parent on behalf of a student, if the borrower establishes, as a defense against repayment, that a school’s actions would give rise to a cause of action against the school under applicable state law.Most of these borrowers would be able to exclude from gross income the discharged amounts based on the insolvency exclusion, fraudulent or material misrepresentations, or other tax law authority.

The safe harbor will also apply to any taxpayer whose PRIVATE loans are discharged by the Department of Education based on the following:

• Participation in legal settlement discharge actions

Federal and state governmental agencies have brought legal causes of action that have resulted in settlements resolving various allegations of unlawful business practices, including unfair, deceptive and abusive acts and practices, against for-profit schools and certain private lenders that made student loans to finance attendance at these schools. Most of these borrowers would be able to exclude amounts discharged as a result of these settlements from gross income based on the insolvency exclusion, fraudulent or material misrepresentations, or other tax law authority

The IRS believes that many of these taxpayers would qualify for forgiveness from recognizing cancellation of debt income under other Internal Revenue Code provisions. However, the IRS wanted to make it easier to qualify for the exclusion—using the new safe harbor provisions. 

Relief is also provided to any creditor that would otherwise be required to file information returns and furnish statements to applicable students.  To avoid any confusion, the IRS recommends that creditors do not provide students or the IRS with a Form 1099-C, Cancellation of Debt. 

This new guidance can be very beneficial to students who are affected by extraordinary circumstances they cannot control. The burden of debt itself is a large enough stress, and if the school closes or there is misconduct, the student isn’t truly receiving the services they have agreed to pay for.