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Cancelled debt as income, part 1: case raises student loan issue

The IRS has long taken the position that cancelled or forgiven debts are generally taxable income.

To be sure, there are certain exceptions to this. For example, in recent years Congress has granted relief for struggling homeowners who have gone through a foreclosure or short sale.

But what about student loans? In this two-part post, we will discuss what can happen when lenders write down student loan debt.

Let’s start with a recent case from Maryland that illustrates how difficult it can be to get hit with a tax bill for cancelled debt.

The case involves the grieving parents of 23-year old man who died unexpectedly of a brain tumor only a few months after graduating from college.

The man’s parents owed about $75,000 in loans they had taken out to help their son attend a private university. Upon their son’s death, the lender wrote off the debt.

That type of debt forgiveness is something lenders often do when a debtor dies or become severely disabled. In 2012 alone, the U.S. Department of Education wrote down about $1.3 billion in debt, on about 55,000 student loans.

In the Maryland case, however, there was another part of the story of the story that was very distressing to the parents. Years after the student loan debt was forgiven, the IRS hit the parents with a bill for taxes on the forgiven debt.

To make matters worse, this is not an isolated case. In part two of this post, we will discuss proposals to change the law, as well as other scenarios in which taxing income from cancelled debt comes into play.

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