In 2017, I negotiated a private student loan debt down from $38,000 to $18,000, and then paid off that balance in its entirety in one lump payment. I received a letter from the IRS claiming that I owe $6,400 since the bank claimed there was a $20,000 loan cancellation associated with this agreement. How can I prove that this wasn't a loan cancellation, but rather a negotiated settlement between two parties?
Perhaps the bank was not totally transparent or did not refer you to or highlight the fine print. In general, any loan balance that is compromised, no matter whether you term it a forgiveness or a negotiated settlement, is treated as income from cancellation of indebtedness, according to IRS Topic No. 431. There are very limited exceptions that exclude student loan debt forgiveness from being recognized as income (generally only death of the borrower, proven disability of the borrower, or certain public service programs where the borrower works for the government in specific roles). Other than these very few exceptions, the tax law provides virtually no relief from the recognition of taxable income from the cancellation of student loan indebtedness. You should have received a Form 1099-C from the bank in January 2018 reporting the income to you and to the federal government for the 2017 year. The IRS assessment of tax relates to that reporting.
Note that the IRS tax topic cited above discusses the student loan compromise/cancellation matter.
Various states may afford the cancellation differently for state income tax purposes. Each state has a website with questions and answers that should provide clarification with respect to the resident state treatment of debt cancellation income.
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Answered by: Timothy C. Hilbert, CPA, is a recently retired director of audit and accounting and professional services industry group leader with Kreischer Miller in Horsham, Pa.