Frank, now 66, lost his job as director of sales of a telecommunications company.
His wife, to whom he had been married for 36 years, died just two months later.
He was still grieving when he learned that he had kidney cancer. The tumor
was operable, but the exam brought to light a long list of other serious problems,
including a pulmonary embolism and a heart-rhythm disorder.
That was in 2009, in the depths of the recession, and finding a new job was
difficult. Two years later, after struggling to pay medical bills not covered by
insurance and other debts, Frank filed for bankruptcy. But that did not erase the
giant pile of federal Parent Plus loans that he had taken out to help put his three
children through college. Since he could no longer work, Sallie Mae, the loan
servicer, ultimately suggested applying for a disability discharge, which would
cancel the debts.
He qualified, and last July, his loans, which had ballooned to $150,000 in
forbearance, were wiped away. “I felt like a Buick had been lifted off my
shoulders,” said Frank, who lives in upstate New York.
But much to his surprise, he received another bill. In January, the Internal
Revenue Service sent him a tax form, known as a 1099-C, which said that the loan
amount had to be treated as income. According to his calculations on TurboTax,
his tax bill for this year is about $59,000.
“If I am not capable to work due to a medical disability to pay the student
loan, how am I supposed to work to pay the taxes?” said Frank, who agreed to discuss his situation only if his full name was not published. “Now I am somewhat
After much criticism, the Department of Education has made it easier in
recent years for disabled borrowers to have their federal student loans discharged.
But now, as more people are qualifying for loan forgiveness, many of them are
running into an unexpected consequence: They are often shocked to learn that
they basically exchanged one debt for another, according to consumer advocates
and tax and credit specialists.
While millions of debts — including credit cards and mortgages — are
canceled each year, the group of borrowers whose loans have been discharged
because of a “total and permanent disability” has grown sharply to more than
115,700 in 2013, from nearly 61,600 in 2011 and fewer than 15,000 in 2008,
according to the Department of Education. But under current tax law, the amount
of debt forgiven is generally taxable, so some disabled borrowers end up with tax
bills they cannot afford.
Borrowers who can prove they were insolvent may be able to ease the tax
burden, but may not be able to eliminate it. And many people do not even know
this exception exists. The insolvency calculation is notoriously complex,
particularly for people who are dealing with medical problems or the death of a
child, consumer advocates said, which is another instance in which student loan
debts may be discharged.
“The government gives with one hand, while taking back with the other,” said
Mark Kantrowitz, a senior vice president and publisher of Edvisors, an
informational website about paying for college. “Morally, if debt is canceled
because of the borrower’s inability to pay due to disability, the corresponding tax
debt should also be forgiven.”
The tax debt is generally a small fraction of the overall debt, but it can present
a great burden because it is due in one lump sum instead of being spread over
time, he added.
“Many borrowers don’t even realize it’s going to be a taxable event,” said
Persis Yu, a lawyer at the National Consumer Law Center who works on the
Student Loan Borrower Assistance Project. “The collateral damage definitely has
potential broad impact. There is the issue of finding affordable housing if they do
have to sell assets to pay for this liability. One of our other concerns is because some people will have this included in their adjusted gross income, they could lose
In some instances canceled debts are not taxable, including debts canceled in
bankruptcy. And student loans may not be taxable for borrowers who work for a
specific period in certain professions, for example.
Insolvency is another exception. Borrowers who can illustrate that they were
insolvent — that is, their total liabilities exceeded the value of their assets — could
potentially lessen or even eliminate the tax burden. The amount of taxable income
can be reduced, but only to the extent of the insolvency.
In other words, if a borrower’s debts exceed assets by $25,000, but a $50,000
loan is forgiven, tax would still be owed on $25,000. “Insolvency is insufficient to
protect many vulnerable borrowers,” Ms. Yu said.
In Frank’s case, when he factors his insolvency in that calculation, he said he
would still owe nearly $25,000 in federal and state taxes. He needed the help of a
tax lawyer to arrive at that reduced figure, which he said the I.R.S. may or may not
Canceled debts are treated as income “to prevent people from using this as a
loophole: lend someone money, they buy something of value, then cancel the debt
and they don’t have to report that money as income,” explained Gerri Detweiler, a
credit specialist with Credit.com. “But unfortunately very vulnerable borrowers are
being swept up in this. They find themselves suffering from a variety of illnesses,
unable to work, and having to deal with the I.R.S.”
The consequences of not paying are serious. The I.R.S. has the authority to
garnish wages, bank accounts and other property, such as automobiles or
retirement savings accounts. The agency can also garnish Social Security and
pension payments, and can file a federal tax lien, which is attached to all property
an individual may own, specialists said. The I.R.S. will also add penalties and
interest to the bill.
If a taxpayer does not pay the amount owed, the I.R.S. will send a bill, which
is the start of the automated collections process. If the borrower cannot work
something out through that process and does not pay, the borrower will receive a
final notice, which says the agency intends to collect what is owed and gives 30
days to comply, said Daniel J. Pilla, a tax litigation consultant and the author of
“How to Eliminate Taxes on Debt Forgiveness,” (Winning Publications, 2013). The letter also notifies individuals of their right to appeal, he added, a process that
stops the collections process.
A few other options are available for people who cannot afford to pay the bill.
If the amount owed is less than $50,000, they can apply for a monthly payment
plan online, according to the I.R.S., or request a plan by filing Form 9465 (people
who owe more than $50,000 must file that form ). Some taxpayers may also
qualify for an “offer in compromise,” where the I.R.S. agrees to settle the tax bill
for less than the full amount.
Mr. Pilla said taxpayers could also try to prove that their monthly income was
consumed by necessary living expenses, which may cause the I.R.S. to deem the
debt “currently not collectible.” “That means they will press the hold button on the
collection machine,” he added.
Some organizations, including the National Council of Higher Education
Resources, a trade group representing student loan servicers and other
organizations, have brought the tax issue to the attention of members of Congress,
but it has not yet gained traction, said Tim Fitzgibbon, vice president for debt
management services at the group.
For now, people who find themselves with large tax obligations have to figure
out how to best navigate the process on their own or with professional help, which
can be hard to find. The I.R.S.’s free tax preparation service for low- and
moderate-income people is not equipped to handle the complexities.
Frank said the tax lawyer he hired to help him negotiate with the I.R.S. was
going to cost him $3,000 to $5,000, and he is making plans to sell his home. “I
have to go through this process,” he said, “which is going to be laborious and expensive."
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