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IRS Insolvency Is Not Like Bankruptcy

The Wall Street Journal recently ran an article about burgeoning graduate student debt. This phenomenon began in the last decade because of the Grad PLUS Loan Program, which covers all tuition charges at graduate and professional schools as well as living expenses. The point was to eliminate private lenders, who weren’t seen as offering fair terms to graduate and professional students.

Graduate loans are usually not dischargeable in a New York bankruptcy, but they are eligible for the many loan repayment programs I wrote about last week. One feature common to them is loan cancellation after 10, 20, or 25 years, which is why the WSJ refers to them as “debt-forgiveness programs” even though that’s not their main purpose.

The WSJ interviewed a lawyer who looks forward to the day when her $300,000 in student loan debt is forgiven. The question the WSJ didn’t ask is, what happens to these debtors when their taxes become due? Unless they were enrolled in the 10-year Public-Service Loan Forgiveness program, these debtors will need to declare their canceled student loans as income.

That April 15 is still a long way off for those debtors, but the situation is similar to when homeowners short-sell their homes and receive Form 1099-Cs from the lenders, so it’s worth discussing.

The main issue for a debtor-taxpayer is whether they are “solvent,” a term the IRS defines in section 108 of the Internal Revenue Code. Understandably, insolvency is essentially when the fair-market value of one’s liabilities is greater than that of one’s assets. When a taxpayer is insolvent, then under section 108(a)(1)(B), he or she need not count the discharged amount as gross income. Incidentally, this section also permits taxpayers to exclude debts discharged in “a title 11 case,” i.e. bankruptcy.

There is a catch, however. Section 108(a)(3) limits the excluded amount to the extent the taxpayer is insolvent. The IRS gives an example of what this means. To paraphrase:

“Greg” has assets of $7,000 and liabilities of $15,000—so a net worth of -$8,000. Greg’s credit card lender cancels a $5,000 credit card debt and sends him Form 1099-C. He is insolvent to the extent of $8,000, so he can exclude the entire $5,000 from his gross income.

In an alternative example, Greg has only $10,000 in liabilities, leading to a net worth of -$3,000. Therefore, he can only exclude $3,000 from his gross income due to the canceled debt. The remaining $2,000 counts as income that Greg must pay tax on. Importantly, this doesn’t mean he must pay all $2,000 to the government, it’s just added to his gross income for the year. He might ultimately pay no more than 35 percent of it, and the example doesn’t even tell us what Greg’s income is.

The point is that people who short-sell their homes but still have other assets—or as we’ll see in the coming decades, highly indebted students—aren’t forced to liquidate all of their assets if their canceled debts would otherwise wipe them out. IRS insolvency is not bankruptcy.

The tax on the forgiven debt must still be paid, and that can lead to other financial problems. If you are interested in short-selling your home, it might benefit you to talk to an experienced New York bankruptcy lawyer.

For answers to more questions about bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced Brooklyn bankruptcy trustee Bruce Weiner for a free initial consultation.

Rosenberg, Musso & Weiner, L.L.P
26 Court St # 2211
Brooklyn, NY 11242, USA

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