One of the peculiarities of tax law is that income from a cancelled debt can count as income.
It's an issue that many homeowners have faced, especially in the wake of the Great Recession. As we noted in a 2014 post on mortgage debt forgiveness, the federal government created a temporary tax exemption after the real estate crisis for income from such transactions. California, however, did not.
In this post, let's look at another way the issue of taxes on debt forgiveness income is playing out: on cancelled student loan debt for borrowers who have become disabled.
Yesterday the LA Times expressed concern in an editorial about potential IRS problems for 387,000 people who are both severely disabled and insolvent and are eligible to have their student loans forgiven. People in this group are facing the forgiven-debt-as-income issue.
In practice, this means that people with total and permanent disabilities could get big tax bills. This could occur even if they had very little, or no, other income.
Senator Elizabeth Warren of Massachusetts has written to the IRS, seeking to get the agency to commit to waiver of tax consequences for disabled people from forgiven student loan debt. Those potential consequences go beyond the taxes themselves. They also include potential loss of Social Security disability benefits for failing to report loan discharge income when filing tax returns.
Senator Warren cites a precedent for the IRS action she is seeking. When the for-profit school Corinthian Colleges went bankrupt amid fraud allegations, the IRS granted relief from debt-forgiveness income obligations to more than 11,000 students.