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Tax Relief For Lucky Debtors

cut up dollar bill and a calculator.
photo courtesy Images Money on Flickr

There is a longstanding general rule in the tax law that says you owe income tax on debts you take on that are later forgiven. Except when you don’t.

The general rule makes sense. But now the exceptions – which generally also make sense – are becoming so numerous that the general rule is not so general anymore. This is the sort of situation that explains why so many people look at the tax law and say it doesn’t make any sense at all.

If you are going to have an income tax, you need a rule like the one that says canceled debt is treated as income. Consider what would happen otherwise. Say I wish to award a handsome sum to Throckmorton, my loyal employee, upon his retirement. I am concerned that my generosity will push Throckmorton into a higher tax bracket, and thus end up rewarding the government more than him. Perhaps I also happen to know that Throckmorton intends to move from his heavily taxed abode in Santa Monica, California or Queens, New York to his retirement dream home overlooking the sugary sands of Clearwater Beach in income-tax-free Florida. My cash award would come in handy to help him get there.

So I hit upon an idea. I will lend Throckmorton the money, rather than make it a gift. I can keep the loan outstanding for as long as he continues to live in that bungalow off Wilshire Boulevard or the row house in Douglaston. Then I can forgive the loan when he gets himself down to the Gulf of Mexico. Or if he stays in his longtime home after all, I can forgive the loan a little bit at a time – not enough to make it look like the disguised bonus that it actually is. Or, in our theoretical world where tax law doesn’t care about forgiven loans, I’ll just write it off all at once as soon as Throckmorton starts collecting his pension.

Real-world U.S. tax law, specifically Section 61(a)(11) of the Internal Revenue Code, says this scheme doesn’t work. The law recognizes income from the “discharge of indebtedness,” which is also sometimes called cancellation of debt income, or COD.

But other parts of the tax law create exceptions to this rule. Some of these exceptions have been around practically forever. They often make policy sense, such as when debt is eliminated in the course of a bankruptcy. Bankruptcy, by design, gives debtors a fresh start. It doesn’t make a lot of sense to create a brand-new debt to Uncle Sam as a consequence of getting old debt eliminated in bankruptcy; the fresh start would be heavily burdened from the beginning.

Other exceptions make sense from a humanitarian or political perspective, but less so as a matter of policy.

The global financial crisis started in 2007 when overextended borrowers began struggling to pay their mortgages on overpriced homes. Many ended up losing the homes to foreclosure, which in some (but not all) cases meant the underlying debt was extinguished. But that debt was partly replaced by a new liability, to Uncle Sam, for tax on the “income” from the canceled mortgage debt.

Congress responded with a temporary fix in the Mortgage Debt Relief Act of 2007. This created an exception to taxation on up to $2 million of mortgage debt on a taxpayer’s principal residence forgiven between 2007 and 2009. Obviously, taxpayers losing homes to foreclosure in 2010 would not have been happy, so Congress extended the deadline – six times so far. The financial crisis is long gone, and most housing markets have fully recovered. But relief from COD tax on mortgage discharges is still in effect through 2020, thanks to the appropriations measure that President Donald Trump signed last December. The old deadline expired after 2017, so some taxpayers who reported such income on their 2018 returns will need to file timely amended returns to get a refund.

The treatment of discharged student loan debt is even more of an inconsistent mess. Such debt is subject to the normal bankruptcy exception, but is seldom eligible for discharge in bankruptcy in the first place.

If a school discounts its tuition through a scholarship grant, the discount is not taxable. But if a student pays full price partly by getting a loan through the school’s financial aid office (which is usually just an intermediary, rather than a lender) and the loan is later forgiven, the loan forgiveness is taxable – even though the net cost to the student is otherwise the same.

But that’s not the end of the story. Most income-based loan repayment plans that include a balance forgiveness component result in taxable income. Most, but not all. Loans forgiven under certain post-graduation work commitments, such as certain programs to benefit newly trained teachers, public employees, primary-care health workers in underserved areas, and lawyers (lawyers?!) in public service are not taxable.

The Internal Revenue Service also carved out an exception for former students at two now-closed for-profit college chains, Corinthian Colleges and American Career Institute, who took out loans that were later discharged by the federal Education Department. The IRS recently extended that exception to other borrowers whose loans are forgiven under the Education Department’s programs for closed schools, or those who are entitled to defenses against demands for repayment. Borrowers with private loans can also avoid reporting forgiven debt as income if their loans were discharged as a result of legal settlements against the school or, in some cases, the lender. To justify the new exception, the IRS asserted that many such borrowers would be entitled to tax exception anyway under the rules for insolvency, even when bankruptcy is not available. The new guidance retroactively applies to loans discharged in 2016 or later.

Amid all these exceptions, borrowers who eventually get their loans forgiven under income-based repayment plans can still expect to pay income tax on the forgiven debt. Unless, of course, legislators create more exceptions in the future.

Right now the general rule requiring tax payments for COD income applies only to borrowers who are not lucky enough to be covered by one of the many exceptions. This may not make a lot of sense. But as a general rule, Congress will do whatever seems sensible amid the politics of the moment without much further thought. In this way, lawmakers can take a lot of individually sensible steps only to arrive at a messy, perplexing outcome.

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