Cancellation of Certain Student Loans
The general rule is that if you are responsible for making loan payments and the loan is forgiven, you are required to include the amount of the cancelled loan in your gross income for federal income tax purposes. However, under certain circumstances, a forgiven student loan may be entitled to tax-free treatment.
In order to qualify for this tax-free treatment, the loan must contain a provision that some or all of the debt will be canceled if you work for a certain period of time, in certain professions, and for any of a broad class of employers. In addition, any loan eligible for tax-free treatment upon cancellation must have been made by a qualified lender to assist the student in attending an eligible educational institution. Qualified lenders include the following:
- The government (federal, state, or local, and any of its instrumentalities, agencies, or subdivisions);
- A tax-exempt public benefit corporation that controls a state, county, or municipal hospital and whose employees are considered public employees under state law;
- An eligible institution, if the loan was made as part of an agreement with a government or a tax-exempt public benefit corporation or under a program of the educational institution designed to encourage students to serve in occupations or areas with unmet needs. In order to qualify, the services required of the students must be under the direction of a government unit or a tax-exempt organization.
Usually, the loan forgiveness takes one of two different forms. First, the educational institution that made the loan can cancel some or all of the debt in exchange for the student’s commitment to serve in a public service occupation. Second, an organization refinances the original student loan and then forgives the refinanced loan in exchange for the student’s commitment to serve the public.
The exclusion for loans made by an educational institution applies only if the student whose loan is forgiven is not employed by the lender organization. In addition, the exclusion does not apply to the discharge of a student loan if the discharge is on account of services provided to the lending organization.