Income from Cancellation of Student Loans

When a creditor forgives some or all of an outstanding debt, that forgiveness usually results in cancellation of debt (COD) income. It’s no different when the debt is a student loan. Take the following case.

A taxpayer who attended college in the 1980s borrowed nearly $20,000 from the Connecticut Student Loan Foundation to pay his education expenses. After he became delinquent in repaying his loan, the foundation sued him and received a default judgment. After the judgment he made three more payments totaling less than $900. The foundation used various collection agencies to continue its efforts to recoup the loan funds; even wage garnishment was tried-all to no avail. Finally, in 2005, he sent the foundation a check for $45,000 with a note saying that this payment was his complete satisfaction of the then-outstanding debt of about $73,000 (after interest). The foundation accepted it, and in 2006 filed documents in state court showing satisfaction of judgment; it issued him a Form 1099-C, Cancellation of Debt, reporting income of $27,000 in 2006. The question for the Tax Court was whether the COD income was taxable to him, and in which year (2005 or 2006).

The Tax Court decided that the COD income was taxable. There was no special rule that the taxpayer could rely on to exclude the income. COD income is not taxed, for example, when a taxpayer is bankrupt or insolvent; that was not the case here.

The Tax Court also decided that the COD income was taxable in 2006. While the taxpayer sent the payment as satisfaction for the debt in 2005, it was not until 2006 when the foundation filed papers in court showing satisfaction of the debt (this is when it was accepted as satisfaction of the debt). It was this point it became clear no additional payments would ever be made.

Source: John Joseph Martin Jr.; TC Summary Opinion 2011-62