Student loan debtors who qualify for debt reduction or debt cancellation may save thousands or tens of thousands of dollars.  Are there tax consequences to these savings?

As you may know, the IRS and many states characterize forgiven debts as taxable ordinary income.  Creditors will send you a 1099 representing the amount of debt forgiveness.

Fortunately, the Internal Revenue Code contains an insolvency exclusion to forgiveness of debt income.  If you (the debtor) are balance sheet insolvent both before and after the cancellation of debt, the ordinary income from the canceled debt is excluded from taxable income to the extent of the insolvency.

IRS publication 4681 gives several examples about how the insolvency exception applies and if you read this publication you will see that the concepts can be somewhat confusing because you must consider your insolvency both prior to and after the forgiveness as well as the amount of the forgiveness.

Here are my recommendations:

1. if you are expecting to complete a debt reduction or cancellation in a calendar year, consult with a tax advisor (a CPA or enrolled agent) to discuss possible tax consequences.  If the potential debt forgiveness is especially large, it would be wise to talk to a tax advisor a year or two prior to the forgiveness year so you can engage in tax planning
2. if you are considering filing for bankruptcy during the tax year in which your student loans are being forgiven, make sure to advise your bankruptcy lawyer about the pending forgiveness.  It may be beneficial to wait until the next calendar year to file bankruptcy so as to preserve your insolvency exception

Many of the high volume tax preparers who advertise on TV may not be knowledgeable about student loan debt forgiveness or the insolvency exception or about bankruptcy implications.  Make sure to raise this issue and do not hesitate to get a second opinion.