If your student loan is discharged or “forgiven” you may be taxed on the amount that is discharged. This may happen now or it may happen in three years from now.
For some people, there is a way to get out of this problem, and for some people there is no way out. Read on . . .
🌻 How to Escape Tax Problems
If you have little or no assets, the IRS has a special reg called “insolvency exclusion” that can get you out of these tax problems.
You need to know about this regulation, and fill out the form. Sadly, many people do not know about it. Luckily, you are here reading this, so now you do.
If you and your spouse do not own a house or have any assets, they insolvency exclusion should be fairly simple: just fill out one form.
If you have assets, it gets more complicated. Insolvency Exclusion rules are complex. I read about them quite a bit before realizing that I still had not properly understood them. Please be careful and research very thoroughly before going forward:
🌻 Good articles on insolvency exclusions
- “Diffusing the Student Loan Forgiveness Tax Bomb”
- Good article on filling out insolvency forms
- https://www.irs.gov/uac/what-if-i-am-insolvent – Insolvency Worksheet (p. 8)
- “Disabled borrowers trade loan debt for a tax bill”
🌻 How Dahlia Escaped Tax Problems
“My federal loans were easily dismissed, but I had a huge scare when I got the tax form and I owed $30,000 in taxes. I was horrified and thought it had to be a mistake but no! Disability does not free you from this tax burden. I filed for insolvency exclusion, and the IRS said I didn’t have to pay. I hired a CPA to help me.
The real terrifying aspect of this story is that if I had been married to someone with a house or if I owned a home, they would have gone after the house. I would have been forced to sell it to pay the taxes due. Talk about getting kicked when you’re already knocked down.”
🌻 Double Check
I am writing this in April 2017 and at this moment in time this tax problem still exists. There have been several proposals to get rid of the tax problems created by disability discharges, but so far they have all been voted down. If you are reading this after April 2017, please take a look and do some research to see if any of these laws have changed yet.
🌻 Tips & traps
- Include everything. When calculating assets, make sure to include everything – all cars, property, houses, stocks, bonds, bank accounts and all financial accounts. In addition, make sure to count your clothes, personal items, furniture, tools, computer, jewelry, retirement plans, pensions, 401k, security deposits, cash face value of life insurance policies, and everything else.
- Plan ahead. For Federal loans, the taxes will hit three years after the discharge. For private loans, check the loan company’s policy. If you don’t have assets now, where will your life be in three years? Is anything going to change? If you are applying for disability, will you get a big backpay check? If someone close to you passes away, will you get an inheritance?
- If you are married, they may or may not count your spouse’s assets and debt. If you are married filing jointly, they will count. If you are married filing separately, it depends on the communal property laws in your state. Some tax advisors recommend to file separately for this reason.
- Interest does not mean interest. On the IRS worksheet it say “interest in pension plans.” That just means the whole value of your pension plan. Tricky!
- You may still owe taxes. Even if you are insolvent, you may still owe some taxes on the discharge. It depends how much you are insolvent by. This is the part I got confused by and had to read more about. Please research carefully.
- Talk to an accountant. This seems like a very good idea to me. I would do this now. Don’t wait til year three.
Giving Things Away
🌻 For everyone: I read an article from one accountant who said that if you give something away and then later get audited by the IRS, the IRS may look to see if it was a “sham gift” that the person then just gave back to you at a later time. I don’t know how often this happens or how it would play out.
🌻 If you are on SSI or Medicaid, do not give away assets or money. Do not transfer a car or house into someone else’s name. If you co-own a house, do not take your name off the deed. All of these things can cause big problems.
🌻 If you plan to be on SSI or Medicaid in the next 3-5 years, everything above applies to you too.
🌻 If you are on SSDI or Medicare, Social Security will not care what you do with your assets.
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