To determine the insolvency amount (liabilities in excess of assets) the IRS takes into consideration all assets owned by the taxpayer including bank accounts, investments, real estate, business ownership, and retirement savings
The exclusion does not apply if the loan terms require the services to be provided to one or a few specified employers, such as a specific hospital. In such a case, the discharge would result in compensation income. Sec. 108(f)(1) specifies that the loan terms must require the student to work “in certain professions for any of a broad class of employers,” and an acceptable broad class ple, hospitals in rural areas in the United States. The exclusion only applies to specified loan forgiveness programs and does not apply to other financial incentive programs designed to attract workers, which are typically considered compensation and do not represent loan forgiveness.
Liabilities may include credit card debt and mortgage debt along with student loan debt
Widely publicized cases of for – profit colleges folding and leaving students with no degree and large amounts of debt have led to the discharge of certain student loans by the U.S. Department of Education. 31 There is both a “Closed School” discharge process and a Defense to Repayment discharge process based on misrepresentations made to students. 32 While these Education Department programs forgive the loans, it remained unclear in some cases whether the debt forgiveness resulted in gross income to the borrower. The IRS was concerned that the analysis involved in determining whether another exception would apply (e.g., the insolvency exception, discussed below) would impose a compliance burden on both the IRS and the students with very little resulting taxable income. As a result, Rev. Procs. 2015 – 57 and 2017 – 24 state that the IRS will not assert that a taxpayer recognizes gross income as a result of the Defense to Repayment discharge process or Closed School discharge process.
In Rev. Proc. 2020 – 11 the IRS expanded the relief for taxpayers who took out federal and private student loans in order to attend institutions that closed or misled borrowers. This procedure provides that if a taxpayer’s federal student loans are discharged under the Closed School discharge process or the Defense to Repayment discharge process or if their private student loans are discharged based on a settlement of a legal cause of action resolving allegations of unlawful business practices, including unfair, deceptive, and abusive acts and practices, against not – for – profit or for – profit schools or private lenders:
- Taxpayers will not recognize gross income from discharged loans;
- Taxpayers will not have to report gross income under the tax benefit rule in the year of discharge for education tax credits, student interest deductions, or qualified tuition-related deductions taken in prior years attributable to the proceeds of the discharged loan; and
- Creditors are not required to file information returns for the discharged debt pursuant to the IRS procedure. 33
34 A taxpayer is insolvent if the taxpayer’s total liabilities exceed the fair market value of their total assets immediately before the discharge. 35 The exclusion only applies to the amount of discharged debt in excess of the taxpayer’s assets. The theory for this exclusion is that the taxpayer should not be burdened with the tax liability on the discharge when the taxpayer is unable to pay the debt or the tax.
Proving insolvency involves a facts – and – circumstances – based investigation, often requiring the individual to seek legal advice and incur additional costs. As a result, borrowers who may qualify for the exception may be unable to take advantage of the exclusion due to the administrative costs.