The Tax Implications of Settling Student Loan Debt

Settling student loan debt can give you financial and emotional relief — but it’s not a pain-free option. Unless you qualify for an IRS exception, you could owe taxes on the amount you settle.

If you settle a student loan for less than the full amount, the creditor will notify the IRS that it canceled the difference between what you owed and what you paid. The IRS treats the amount of the canceled debt as taxable income on your federal income tax return. Depending on where you live, your state’s tax office may do the same.

Keep reading to learn what student loan settlement means for your tax bill.

A student loan settlement is an agreement between the lender and the borrower in which they negotiate a reduced amount to pay off the debt in full. The borrower benefits because they are able to pay off less than the full balance of what they owe. At the same time, the creditor gets some compensation for the debt and won’t have to write off the entire amount. Of course, the settlement comes with a price: it will appear on your credit report as a settled debt and might hurt your credit score because the credit bureaus consider it to be a negative mark.  Your tax bill may also increase.

A settlement is different from student loan forgiveness, which cancels your remaining debt entirely and is tax-free — at least through December 2025. This is due to the American Rescue Plan Act that President Biden signed into law last March.

With a settlement, the difference between what you paid and what you owed is considered to be taxable income by the IRS. You’ll need to be prepared to pay taxes on the forgiven amount.

If you’re considering settling your private or federal student loans, it’s important to talk to a tax professional to ensure that you understand all of the implications before making a decision.

Learn More: Should I Pay Off My Student Loans in One Lump Sum?

After you pay the settlement amount in full, the lender or debt collection agency may send you a Form 1099-C, Cancellation of Debt tax notice for the tax year the settlement was paid. This information will also be sent to the IRS, and you’ll need to report it on your federal tax return.

You’ll have to pay taxes on the amount settled unless you can exclude it from your gross income. You may qualify for an insolvency exclusion if your total liabilities exceed your total assets. You also can qualify for the bankruptcy exclusion if you settled the debt in a student loan bankruptcy case.

You can apply for the exclusion using Form 982 – Reduction of Tax Attributes Due to Discharge of Indebtedness.

The balance that’s waived as part of a settlement likely won’t qualify for the American Rescue Plan Act because it is not considered to be forgiven debt. The IRS has not yet given guidance on whether a debt that’s canceled as part of a settlement is treated differently under the Act than debt discharged under a student loan forgiveness program like the Public Service Loan Forgiveness Program or income-driven repayment plan forgiveness.

If you are in the process of settling your student debt and are unclear about how it will be taxed, it’s a good idea to speak with a tax professional.

Learn More: What Happens if You Default on Private Student Loans?

The amount of taxes you owe on the canceled debt depends on your filing status and tax bracket, ranging from 10% to 37% for the 2022 tax year. In the United States, the last dollar that a taxpayer earns is taxed more than the first dollar. Under this progressive tax system, you’ll pay a higher tax rate on the debt if it causes your tax bracket to increase.

If you don’t qualify for an exclusion, you can set up a monthly payment plan with the IRS and state tax agency to make payments toward the tax debt.

You can also try negotiating an offer in compromise, which would allow you to pay a reduced amount in taxes. It’s hard to get — few taxpayers get that type of debt relief.

To qualify, you have to prove to the federal government that you don’t have any assets or income to pay off the debt in a reasonable time. If you have money now or will likely have it in the future, negotiating a compromise will be nearly impossible.

I can help you decide if settling your student loans is the best option for you. Schedule a call with me today. We’ll go over possible settlement options as well as alternatives like refinance or loan repayment programs that fit your needs and goals.

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