Student Loan Discharge: Insolvency, Bankruptcy, and Forgiveness

There are two types of student loan discharges where insolvency plays a role:

• Those that occur because your debt was forgiven through a program like Public Service Loan Forgiveness.

• Those that come after a bankruptcy judge determines you’ve met the undue hardship standard.

With loan forgiveness, many people want to find out how to avoid paying taxes on the forgiven amount. The IRS has a loophole for taxpayers who are insolvent at the time the debt is canceled. I’ll go over that below. For now, it’s important to know that all student loan forgiveness is tax-free for the next few years.

A provision in the March 2021 COVID-19 relief package stipulates that any debt forgiven between Dec. 31, 2020, and Jan. 1, 2026, won’t be considered as income. Without this change, debt forgiven under certain forgiveness programs would be reported to the IRS as income and subject to current tax brackets.

There once was a time when Americans could race to bankruptcy court, claim insolvency, and seek a fresh start from all of their debts — including their private loans. But Congress changed student loan bankruptcy laws over time to make it harder for debtors to clear their loans this way.

Borrowers who want to have their student debt wiped out must now file not only a bankruptcy case — usually a Chapter 7 bankruptcy — but also a separate lawsuit known as an adversary proceeding. In the AP, they’ll have to convince the judge that their current income isn’t enough to repay their loans and is unlikely to change during the repayment period.

Related: Can You File Bankruptcy on Student Loans?

Winning student loan bankruptcy cases, especially for federal loans, is challenging, even in dire situations. The forgiveness programs offered by the U.S. Department of Education cap monthly payments at a portion of a borrower’s income. If they still can’t afford their payment under an income-driven repayment plan, they could put their loans on hold temporarily with a deferment or forbearance.

Private loans don’t offer the same benefits, so it’s often easier to pass the undue hardship standard required to discharge your loans.

Related: Can Private Student Loans Be Discharged in Bankruptcy?

Your student loan debt could make you insolvent in the eyes of the IRS if you have more liabilities than assets. The IRS considers taxpayers insolvent when their total liabilities exceed their total assets. Your liabilities include your federal and private student loans, mortgage, auto loan, and so on. Your assets include the money in your bank accounts and 401k, any stocks you own, and the value of the property you own (house, car, jewelry, electronics, and so on).

Being insolvent doesn’t mean that your student loan debt would automatically be discharged in bankruptcy. To do that, you’ll typically need to pass the Brunner Test by demonstrating you’ve made a good-faith effort to pay your student loans, but try as you might, you can’t pay the loans and maintain a minimal standard of living.

Although insolvency won’t lead to an automatic student loan bankruptcy discharge, it can help you avoid paying taxes on money that your lender cancels as part of a settlement or forgiveness after 20+ years of making payments under an income-based repayment plan.

When it’s time to prepare your taxes, use the Insolvency Worksheet to calculate your insolvency amount. If that amount is more than the canceled or forgiven debt, then you can exclude it from your income and not pay taxes on it.

Related: Can You Negotiate a Student Loan Payoff?

Example — The insolvency amount is more than the canceled debt

Greg settled his federal student loans in 2021 for $20 thousand less than the outstanding balance. The Education Department sent him a 1099-C indicating a debt cancellation for that amount. Greg uses the Insolvency Worksheet and calculates that his total liabilities immediately before the debt was canceled was $50 thousand, and the fair market value of his assets was $7 thousand.

This means Greg was insolvent by $43 thousand before settling the loans. He can exclude the entire $20 thousand from his income because the amount by which he was insolvent immediately before the cancellation was greater than the amount he saved with the settlement.

Student loan debt isn’t forgiven or discharged at the end of your bankruptcy case. To get rid of your loans, you’ll need to do two things:

• Initiate a second bankruptcy proceeding known as an adversary proceeding.

• File a Complaint to Determine Dischargeability of Student Loan Debt.

Your lender will have a chance to respond. Evidence will be provided. And ultimately, the bankruptcy judge will determine whether student loan repayment would be an undue hardship to you and your dependents. If it would, the court will enter an order granting a student loan discharge. If it wouldn’t, the court will rule against you, and you’d have to start making your student loan payments soon after.

Learn More: Why Aren’t Student Loans Forgiven in Bankruptcy?

It’s possible to earn credit towards different student loan forgiveness programs while you’re in bankruptcy, but it’ll take more work and — if you’re in a Chapter 13 bankruptcy — permission from the bankruptcy court.

Here’s why.

The bulk of your Chapter 13 plan payments goes toward the repayment of your secured debt (mortgage, auto loan, and so on), the trustee, and your bankruptcy attorney. Your medical bills, credit card debt, and other unsecured debts will equally share whatever’s left. Your student loans receive a fraction of the total monthly payment under this distribution scheme.

Related: What Happens to Student Loans in Chapter 13?

But to get your loans forgiven because you work for the government or a nonprofit, or made payments for at least 20 years, each payment must be for the full amount due. Partial payments don’t count. As a result, many student loan borrowers leave Chapter 13 after several years, having made no progress toward Public Service Loan Forgiveness or Income-Driven Repayment Plan Forgiveness.

You can avoid this problem by asking the bankruptcy judge to allow you to pay your student loans outside of your Chapter 13 plan or let you increase the amount of money your lender gets inside of the plan.

Related: Can Parent PLUS Loans Be Discharged in Bankruptcy?

Being insolvent can help you avoid paying taxes on any amount forgiven by the Department of Education or your private student loan lender. But it won’t automatically lead to the court discharging the remaining balance owed for your education loans when filing bankruptcy.

The Bankruptcy Code considers student loan debt nondischargeable unless the borrower’s financial situation prevents them from paying back their loans and bills. Most people don’t try to offer that proof, and those that do, typically lose because the bar to discharge student loan debt is high.

Let’s talk if you want help figuring out a plan for your student loans. I’ve helped hundreds of people just like you find a path forward that lets them see the light at the end of their tunnel.

UP NEXT: Biden’s Student Loan Forgiveness Plan