There are also some non-tax-law provisions that allow student loan borrowers to exclude cancellation of debt (COD) income when the U.S. Department of Education discharges federal student loans.

For this purpose, federal student loans include federal Family Education Loans, federal Perkins Loans and federal Direct Loans. For example:

The closed school procedure. The Department of Education can discharge a federal student loan when the student was attending a school at the time it closed or if the student withdrew within a certain period before the closing date. COD income from federal student loans that are discharged in this situation are tax-free and shouldn’t be reported as taxable gross income on the borrower’s federal income tax return.

The defense to repayment procedure. Under this procedure, the Department of Education is required to discharge a federal Direct Loan if a student borrower establishes, as a defense against repayment, that the school’s actions would give rise to a cause of action against the school under applicable state law. Federal Family Education Loans can also be discharged under this procedure if certain additional requirements are met.

There’s no statutory rule that provides tax-free treatment for COD income from loans that are discharged under this procedure. But the taxpayer (student loan borrower) may be able to exclude COD income amounts under other tax-law exceptions (such as the aforementioned insolvency exception or bankruptcy exception) or under an IRS-approved nonstatutory exception (such as the one for Corinthian College student loan borrowers, as explained below).

One College Case and Tax Relief for Student Borrowers

The Department of Education has been discharging federal student loans that were taken out to finance attendance at schools owned by Corinthian Colleges, Inc. (CCI). The government estimates that more than 50,000 borrowers may be eligible for discharges under this program. The discharges are made under the Closed School or Defense to Repayment discharge procedures, based on misrepresentations made by the school.

CCI has been the subject of multiple federal and state investigations regarding whether it misled students about its financial condition and its job placement rates. CCI sold more than half of its campuses in late 2014 and then abruptly closed its remaining schools in April of 2015. These actions left some 16,000 students in limbo. CCI filed for bankruptcy in May of 2015. Afterwards, the Department of Education announced federal student loan relief for affected students.

In IRS Revenue Procedure 2015-57, the agency states that taxpayers who took out federal student loans to attend schools owned by CCI qualify for tax relief if the loans are discharged under the Department of Education’s Closed School or Defense to Repayment procedures. These taxpayers don’t need to recognize taxable gross income as a result of the discharges. The IRS also states these taxpayers aren’t required to increase their federal income tax or taxable income to account for higher education tax credits, deductions for tuition and fees, and deductions for college loan interest that were claimed based on expenses financed by the discharged loans.

The Bottom Line

You or someone you know may have benefited from discharges of federal student loans. If your employer pays off your federal student loans, that’s a great fringe benefit. However, it’s not necessarily good news from a tax perspective. That’s why it’s important to understand both the advantages and possible negative consequences of student loan discharges.

If you have questions or want more information, contact your tax advisor.