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Disabled borrowers trade loan debt for IRS tax bill

Frank got his student loan debt discharged, but he now owes an estimated $59,000 in taxes because the loan is now considered income.HEATHER AINSWORTH/The New York Times

Six months after his wife learned that she had a rare vascular disease of the brain, 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 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 panicked.”


After much criticism, the Education Department 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.

“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.”

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,” 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 IRS may or may not accept.

The consequences of not paying are serious. The IRS 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 IRS will also add penalties and interest to the bill.

If a taxpayer does not pay the amount owed, the IRS 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.”


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 IRS, 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 IRS agrees to settle the tax bill for less than the full amount.

Pilla said taxpayers could also try to prove that their monthly income was consumed by necessary living expenses, which may cause the IRS 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 IRS’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 IRS 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.”