Generally speaking, when you are relieved of a debt outside of bankruptcy, such as when a bank forgives a mortgage, you may experience forgiveness of indebtedness income.
It is kind of counterintuitive to think that forgiveness of debt can lead to “phantom income” on your tax return, especially because those funds were not paid to you as the time the debt was forgiven. However, the law sets out income tax consequences to somebody that receives a discharge of their debt.
There are certain exceptions to this provision, including the insolvency exclusion. Generally speaking, if you were insolvent immediately before the forgiveness of indebtedness, and if you were still insolvent immediately after the forgiveness of indebtedness, the law allows you to exclude the discharged amounts as income on your tax return.
But what if you owe money to the Department of Education regarding a Federal Direct student loan if the school that you attended closed down or if you withdrew from the school within a certain period of time? If the Department of Education discharges that debt, do you have to report that on your income tax return? The answer may lean towards no.
If your school closed down or if you withdrew as a student from the school within a certain period of time, you can ask the Department of Education to discharge your Federal Direct student loan.
If you meet these provisions, then the discharge of your student loan debt by the Department of Education is not a taxable event on your tax returns. As always, we recommend that you hire a qualified CPA to prepare your tax returns for you, especially if you have discharge of indebtedness issues.
Do you owe money to the IRS or have unfiled tax returns? Contact us, we can help. Call us before the IRS calls you!®