Tax Impact of Receiving a Settlement on Student Loan Debt

I met with a friend of mine for lunch several weeks ago and during our conversation he asked me a question concerning his sisters’ student loan situation. His sister was in the process of completing her medical residency at a prominent New York hospital and had significant student loans related to her medical school studies. The loans were borrowed from a private lender (i.e. a bank) and not a governmental entity and were split into 6 tranches with two of those tranches in technical default. Those two tranches had been passed onto a collection agency by the bank that made the original student loans. The collection agency offered to settle the debt for a smaller lump sum payment and the remaining loan balance would be written off. I noted I would have to do some research with regard to the tax impact of the lender accepting the settlement of the debt and the treatment of the forgiven debt.

Generally, the IRS defines gross income to include “ income from the discharge of indebtedness.” With regard to student loan debt, there is a special rule that allows exclusion of student loan discharge amounts from being included in gross income. In order to qualify for the exclusion, the loan must be made by:

• Federal, State or Local government unit or agency or subdivision;
• A tax exempt public corporation that has assumed control of a state, county, or municipal hospital and whose employees are considered public employees under the laws of that specific state;
• An educational institution that makes the loan under one of the following:
  • An agreement with an entity described in either provision 1 or 2, or
  • The program of the institution to encourage students to serve in occupations or in areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or other tax-exempt organization

If the debt does qualify under the above provisions and there is a discharge of the debt, the discharged amount would not need to be included in gross income and taxed to the individual.

In the scenario above, my friend’s sister did not meet the allowed exclusion criteria and she would have to include the debt discharge amount in gross income because the student loans were borrowed from a private lender.