In the wake of the housing market collapse, many people have become familiar with the concept of cancellation of debt (COD) income. The basis for COD income is found in IRC § 61(a)(12) which states that gross income includes “income from the discharge of indebtedness.” Understanding the logic of this provision can be tricky. When a loan is given, neither the lender nor the borrower have any gain or loss. The lender has no loss because it expects to be repaid and the borrower has no gain because it expects to have to repay loan. Thus, at this point, there is no “accession to wealth.” However, once the lender agrees to forgive a debt, there is a loss which the lender can (usually) claim on their taxes. Conversely, the borrower has been provided with funds which they no longer have to repay. Thus, once the debt has been forgiven, the borrower has income which must be reported and taxes on that income which must be paid. This income is typically reported to the IRS using on a Form 1099-C.
Section 108 of the IRC has exceptions from the realization of COD income. These include:
- Where the discharge occurs in a title 11 bankruptcy case,
- If the discharge occurs when the taxpayer is insolvent,
- If the indebtedness discharged is qualified farm indebtedness,
- In the case of a taxpayer other than a C corporation, when the indebtedness discharged is qualified real property business indebtedness, or
- In the case of qualified principal residence indebtedness which is discharged before January 1, 2013.
Generally, student loans which are forgiven in the case of the death or disability of the borrower are counted as income by the IRS. However, the IRS has a policy of not seeking taxes when the borrower dies. Unfortunately this does not hold true when the borrower is a deceased student’s family member. This is what happened to the mother of Roswell Friend and the family of Lance Cpl. Andrew P. Carpenter. In the Friend case, a mother was hit with a $14,000 tax bill by the IRS for the forgiveness of a $55,400 parent plus loan after her son committed suicide. In the Carpenter case, a solder died last year as a result of injuries sustained during his second tour in Afghanistan after taking out a loan for community college, leaving his widow and son with a nearly $2,000 tax bill.
In response to the Carpenter case, remedial legislation has unanimously cleared the House of Representatives, as lawmakers voted 400-0 to approve the Andrew P. Carpenter Tax Act. The bill would prevent the IRS from collecting taxes on any amount of college loans that are forgiven following the death of an active service member. If enacted into law, the measure would have a retroactive effective date of Oct. 7, 2001, which marks the beginning of U.S. military operations in Afghanistan.
As for Ms. Friend, it appears that no immediate relief for her and other private citizens like her will be forthcoming. Her best bet may be to work out a payment plan with the IRS if she cannot settle the tax debt outright.
This just goes to show that it can be difficult to plan ahead for the tax consequences which may result from the untimely death of a loved one. Certainly, the outcomes described above are not what most would expect to occur when their family member takes out a student loan. Sometimes, the best that can be done is to make sure you understand your responsibilities before signing a loan guarantee and to seek help after a tragedy occurs in order to effectively communicate with the IRS and work to reach a solution which is acceptable to all parties. One thing that is for sure is that it is never a good idea to ignore the IRS, because they will not go away, especially if they do not know your story and the circumstances which led to the tax issue in the first place.