Student loan borrowers who apply to have their loans canceled due to their disability or the death of their child can worry about one less thing: possible tax consequences.
When a borrower dies or becomes permanently disabled before paying off student loans, the loans can be discharged, relieving the disabled borrower or surviving family members of the burden of paying off loans they often cannot afford. Parent PLUS loan borrowers are also eligible for the death discharge if the student for whom the PLUS loan was taken out dies. These discharge programs provide important relief to borrowers dealing with difficult circumstances. But the programs have come with a big catch: the possibility of a very large tax bill.
We here at NCLC have been arguing for years and years (and years!) that taxing disability and death discharges is grossly unfair to some of the most vulnerable student loan borrowers. Finally, after many years of advocacy, this tax has come to an end… for now (more on that later). The tax bill passed at the end of 2017 does away with the tax on student loan discharges for death and disability.
This is generally good news for borrowers. But there are some complications for borrowers whose loans were already discharged or approved for discharge prior to 2018.
Sorting out tax consequences for loans already discharged or approved for discharge
This new law takes effect January 1, 2018. This means that any loans that were discharged in 2017 are still potentially taxable, and those borrowers should have received a 1099-C in January. In determining whether the loans are taxable, the most important question to figure out is: when does discharge occur?
For loans discharged due to death or based upon a Veterans Administration’s disability determination, the answer is pretty simple. These loans are discharged when the discharge application is approved and the loans are forgiven. So borrowers who received these cancellations in 2017, unfortunately, still have to deal with the tax consequences. These borrowers should know that there are some exceptions to taxation that may apply, such as insolvency – where a borrower’s debts exceed his or her assets. Borrowers who receive a 1099-C should be sure to seek competent tax advice.
However, other disability discharges—those a borrower obtained by having a doctor certify the disability or based upon a Social Security Administration determination —are subject to a three-year monitoring period. In this monitoring period, borrowers must follow certain steps and meet certain income requirements, otherwise their loans are reinstated. For these borrowers, we have been told that the loan is not actually discharged for tax purposes until the three-year monitoring period has ended. Therefore, borrowers who had a disability discharge approved in 2015, 2016, or 2017 but who are still subject to the three-year monitoring period should not be taxed on this discharge, because the discharge will not formally occur until monitoring period ends in 2018, 2019, or 2020, respectively. Borrowers in these categories may wish to seek competent tax advice.
Complications for borrowers whose monitoring period ended in 2017
Borrowers whose monitoring period ended in 2017 will not benefit from the removal of this tax, since it only applies to discharges finalized beginning in 2018. However, these borrowers may experience some complications due to a change in the Department’s policy regarding when to send 1099-C’s to borrowers approved for disability discharges.
Prior to tax year 2015, the Department’s policy was to send a 1099-C to the borrower at the time when the disability discharge was initially approved. Then, in January 2016 (tax year 2015), the Department changed its policy and decided to instead send the 1099-C after the three-year monitoring period had ended. We were concerned about what would happen to borrowers whose disability discharges were initially approved in 2014—and who had received a 1099-C for tax year 2014 based on the Department’s old policy—when they completed their three-year monitoring period in 2017. Would these borrowers receive yet another 1099-C in January 2018 for tax year 2017, based on the Department’s new policy? According to sources inside the Department of Education, those borrowers should not receive a second 1099-C. But it is a good idea for borrowers in this circumstance to consult a tax professional for more information.
This tax relief is scheduled to expire at the end of 2025
It is important to note that this change in the tax code will expire on December 31, 2025. This means that because of the three-year monitoring period, borrowers who have their initial discharge approved after December 31, 2022 and complete the three years of monitoring could be subject to the tax. The hope is, of course, that this law will be extended or become permanent before then.