Discharge of Debt Income Laws

Discharge of debt income refers to the monetary value of debt discharged under the bankruptcy process or other circumstances. Under most tax laws, this forgiven amount is typically considered taxable income, implying that you may owe taxes on the amount of debt that is no longer required to be paid back.

When Will “Discharge of Debt” Not Be Considered Income?

There are several scenarios under which discharge of debt may not be counted as income. One such situation is if a taxpayer is deemed insolvent immediately before the discharge. “Insolvent” means that a person’s total debts surpass the fair market value of their total assets.

What Does It Mean to Be Insolvent?

Being insolvent means that an individual or entity’s liabilities (or debts) exceed the total value of their assets. Essentially, if the fair market value of everything you own is less than the total amount you owe, you are considered insolvent.

What Happens if the Debt Discharged Is More Than the Amount by Which the Taxpayer Is Insolvent?

If the discharged debt amount exceeds the insolvency amount, then only the amount up to the point of insolvency can be excluded from income. The excess typically becomes taxable unless another exception applies.

What Is Qualified Real Property Business Indebtedness?

Qualified real property business indebtedness refers to specific debts connected to real property used in a business. In certain conditions, a discharge of such a debt may be excluded from income. This is especially true when the debt was incurred or assumed to acquire, construct, or substantially improve the real property.

Here’s a closer look at situations where this might apply:

• Origination of Debt: The debt must have been taken on or assumed to acquire, construct, or make substantial improvements to the real property used in a trade or business. For example, if a business owner takes out a loan to renovate a commercial property or build a new storefront, this would fit the criteria.
• Secured Debt: The debt must be secured by the real property. That means if the borrower defaults on the loan, the lender has the right to take the property through foreclosure or some similar process.
• Reduction in Debt: In some situations, a lender may agree to reduce the principal balance of the loan (rather than completely discharging it). If so, this reduction might qualify for the exclusion. This is common in situations where a commercial property’s value has significantly declined, and the borrower and lender renegotiate the terms of the loan.
• Foreclosure or Sale: The property could have been foreclosed upon or sold, and the proceeds are less than the amount owed (creating a deficiency). In that case, the lender might agree to forgive or discharge that deficiency. This discharged amount, under the right conditions, could be excluded from taxable income.
• Restructuring Agreements: Sometimes, as part of a loan modification agreement, the lender and borrower might agree to change the terms of the loan. If, during this process, any portion of the debt is forgiven or discharged, it might be eligible for the exclusion.
• Exclusion Limitations: There are limits to how much-discharged debt can be excluded. Typically, the exclusion can’t exceed the cost of the original acquisition or substantial improvement of the property. Also, the exclusion is generally capped at the fair market value of the property minus the remaining loan amount (before the discharge).
• Reduction in Basis: It’s important to note that if a taxpayer excludes discharged debt income under this provision, they often have to reduce the basis of their property by the same amount. This can impact the taxable gain or deductible loss when the property is later sold.

As always, the specifics can vary based on individual circumstances, and there are additional rules and exceptions not covered here. Therefore, property owners or businesses facing these situations should consult with a tax professional or attorney to ensure they’re compliant with tax laws and to understand all potential implications.

Can Discharge of Student Loans Be Excluded From Income?

In certain situations, the discharge of student loans can be excluded from income. Typically, this exclusion applies if the loan has a provision where it can be discharged due to the debtor working in specific professions for a set period.

Here are the situations where this might apply:

• Public Service Loan Forgiveness (PSLF): This program is available for borrowers who work full-time for a qualifying employer, typically a government organization or a non-profit. After making 120 qualifying monthly payments under a qualifying repayment plan, the remainder of the loan is forgiven. The forgiven amount under PSLF is not considered taxable income.
• Teacher Loan Forgiveness: This program is designed for teachers who serve in low-income schools or educational agencies. After five consecutive years of service, teachers can qualify for up to $17,500 of loan forgiveness on certain federal loans. Like PSLF, the forgiven amount is not taxable.
• Loans Discharged Due to Death or Disability: If a student loan is discharged due to the death or total and permanent disability of the borrower, the discharged amount is not considered taxable income.
• Closed School Discharge: If a borrower couldn’t complete their program of study because their school closed, they might be eligible for a discharge of their federal student loans. This discharged amount isn’t taxable.
• Defense to Repayment: In situations where a school has misled a student or engaged in other misconduct in violation of certain state laws, students might be eligible to have their federal loans discharged. The forgiven amount, in this case, isn’t treated as taxable income.
• Loan Repayment Assistance Programs (LRAPs): Various professions, notably law, offer LRAPs where, if graduates work in public interest or underserved areas for a set period, a portion of their loans may be paid off by the program. The taxability of the assistance varies based on the program’s specifics and the nature of the employment.

Private student loans might have different rules and are not typically eligible for these government-sponsored forgiveness programs.

Income-Driven Repayment Plans

The Biden administration has introduced a new plan called the Student Aid and Value Enhancement (SAVE) Plan, which aims to simplify and improve the existing income-driven repayment (IDR) plans. Under the SAVE Plan, borrowers would pay 10% of their discretionary income (the amount that exceeds 150% of the poverty line) for 20 years, regardless of their loan type or amount.

After 20 years of payments, any remaining balance would be forgiven and not taxed as income. This plan would also provide more benefits for borrowers who work in public service or teaching, as well as those who face economic hardship or unemployment.

Second, the Education Department has issued a sweeping new student loan forgiveness guidance for a one-time adjustment. This adjustment is designed to provide borrowers with retroactive credit toward IDR loan forgiveness on 20- or 25-year terms, as well as toward Public Service Loan Forgiveness (PSLF). This means that past periods of repayment, deferment, and forbearance might now count toward your IDR forgiveness. Borrowers with certain non-direct loans may need to take action by the end of 2023 to benefit from this adjustment.

Third, the student loan pause that was enacted in response to the COVID-19 pandemic is set to end on August 31, 2023. This means that interest will start accruing again, and payments will resume in October. However, advocacy groups and elected officials are urging the Biden administration to move forward and quickly implement new student loan forgiveness, even after the Supreme Court struck down President Biden’s sweeping debt cancellation plan last June.

Are There Exceptions to the Discharge of Debt Income Exclusion Rules?

Yes, there are exceptions to the general rule of counting discharged debt as income. These exceptions include insolvency, certain types of student loan discharges, and the aforementioned qualified real property business indebtedness.

Do I Need an Attorney to Help Me With My Tax Problems?

If you’re facing tax issues or have concerns about how a debt discharge impacts your taxable income, consulting an attorney is advisable. Find a tax lawyer with experience in these areas through LegalMatch to ensure your rights are protected and to get clarity on your tax obligations.