The Situation
This is less a story about student loan forgiveness than it is the potential tax consequences of obtaining forgiveness. Lt. Milzarski, a retired veteran suffered serious injuries in Afganistan (and is considered permanently disabled). Milzarski applied for and was given loan forgiveness of about $223, 000 in student loans. The disable veteran thought he was in the clear but he wasn’t. Forgiveness of debt, which includes student loans, is a taxable event, though there are some exceptions. I cannot tell from the article exactly what happened but it appears that Milzarski owes $70,000 to the IRS and to state tax authorities.
Up to this point, the IRS has refused to settle for less than the full amount and is currently garnishing his disability benefits; the IRS has also placed a lien on his home. All of this obviously is making life very difficult for the veteran. While I understand the underlying reason it still seems a harsh result, especially for someone who fought for our country. I don’t know if this is the end of the story. Currently, Milzarski is appealing his case through the IRS with the help of a local low-income taxpayer client. So there may still be hope. This case highlights the issue that even if the student loans are forgiven you may not be done with them yet.
The Law
Milzarski’s problem arises because of IRC 108, titled Income from the Discharge of Indebtedness. Generally, cancellation of debt (credit cards, loans, home mortgage, student loans, etc) is a taxable event. The reason is that taxpayers who obtain money, goods or services in return for a promise to pay later obtain a benefit when the debt is forgiven or otherwise reduced. Now in most cases the reason the debt is discharged for less than the full value is that the debtor cannot pay the full amount. The idea that you owe taxes on a loan that cannot be paid in the first place absolutely floors people.
As I said above, exceptions do apply. The most common being debts discharged in bankruptcy and that the taxpayer is insolvent. The article does not discuss Milzarski’s situation in detail but I believe he did not file bankruptcy and so he likely would qualify for the insolvency exception. The taxpayer is relieved from paying tax on any amount of debt discharge income to the extent he or she is insolvent. On the day the debt is discharged, the taxpayer adds up all of his or her assets and reduces that total by any debts that are due. My suspicion is that he had total assets exceeding his total liabilities and so a large portion of his forgiven student loan debt was taxable.
Once taxes are due the IRS can take steps to collect on that debt such as filing a lien on your property; garnishing your wages and benefits; seizing money from your bank account; and, intercepting your tax refunds.
So what does this mean for you?
The reason I am sharing Milzarski’s story with you is to remind you about potential tax consequences of a student loan discharge. This is why I personally like using bankruptcy to deal with student loans as any debt forgiven is absolutely not taxable. I understand bankruptcy carries with it a certain stigma and so if you want to instead have your loans forgiven just realize the potential tax bite you face.
You can read the whole story at USA Today. Here is a link: https://www.usatoday.com/story/news/nation-now/2017/10/20/student-debt-forgiven-but-wounded-vet-gets-62-k-tax-bill/786381001/
If you have any questions about student loan forgiveness or discharge of indebtedness income, feel free to call me at 207-299-0515 or email me using my contact form.
