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?