Student Loans and Forgiveness of Debt-What Parents Need to Know

October 3, 2012

According to American Student Assistance, It is estimated that every year, of the twenty million students attending college, twelve million borrow money to pay for their tuition.  In addition, approximately thirty seven million Americans have outstanding balances on student loans.  It is clear that student loans play a significant role in funding our college educations.

It is also common for the parents of a student to cosign the student loan, making the parent liable for repayment if the child is unable to do so.  Alternatively, parents can borrow funds directly through a Federal Parent Plus Loan to pay for their child’s college tuition.  However, cosigning or taking out a Parent Plus Loan can lead to a less obvious tax liability in the form of forgiveness of debt income.

What is forgiveness of debt income?  Let’s suppose Mary loans John $50,000 to be paid back over ten years with interest.  At that point, because John has to pay back the amount he was loaned, it is not considered income to him for tax purposes.  Two years into the loan, John still owes $40,0000 but suffers some sort of personal or financial setback.  Mary, feeling sympathetic, cuts a deal with John that she will accept a $10,000 payment to satisfy the loan, thus forgiving the remaining $30,000.  According to the IRS and relevant tax law, John has realized income of that $30,000 because he received it and no longer has the obligation to pay it back.  That is John’s forgiveness of debt income.

With regard to student loans, there are some situations in which they may be forgiven.  The Baltimore Sun recently reported a tragic situation regarding a mother who took out a $55,400 Parent Plus Loan to pay her son’s tuition at Temple University.  Sadly, her child committed suicide while he was still a student.  As is typical when a student passes away, the mother’s lender forgave the Parent Plus Loan.  However, the IRS informed the mother that she had forgiveness of debt income of the entire amount of the loan and that, as a result, she owed $14,000 in additional taxes.  This result occurred because, pursuant to IRS rules, while the IRS will not seek to collect taxes on forgiveness of debt income at the death of the borrower, it will seek to collect when a borrower, in this case the parent, is still living. 

While it is possible that, through negotiations with the IRS, the mother may be able to get her tax liability reduced or even completely erased, the process will be lengthy and require the mother to produce extensive financial data (similar to an audit).  Additionally, although many tax experts have criticized the IRS’s position, deeming it an oversight of the law, there are currently no legislative or administrative attempts to change this outcome.  As a result, parents who have cosigned their children’s student loans or borrowed money to pay for their children’s education should seek the advice of a tax professional in situations involving forgiveness of debt income.

Matthew Grosh is an attorney at Russell, Krafft & Gruber, LLP in Lancaster, Pennsylvania. He received his law degree and LL.M. in Taxation from Villanova University.