Private Student Loans Guru

Federal Student Loan Forgiveness and Discharge

By Mark Kantrowitz

Federal student loans are eligible for two types of loan forgiveness, front-end loan forgiveness and back-end loan forgiveness. Front-end loan forgiveness cancels a portion of the borrower's debt each year. Back-end loan forgiveness cancels all remaining debt after a period of time in repayment.

Public Service Loan Forgiveness

The most popular type of loan forgiveness is Public Service Loan Forgiveness, a back-end loan forgiveness program. Borrowers are required to work full-time in a public-service job while repaying their loans in the direct loan program in standard repayment or one of the income-driven repayment plans. After 120 payments (10 years), the remaining debt is forgiven.

Since standard repayment would pay off all the debt in 10 years, the borrower must earn forgiveness by using one of the income-driven repayment plans. The standard repayment plan is provided as an option for preserving the loan forgiveness when the borrower no longer qualifies for one of the income-driven repayment plans.

Up-Front Loan Forgiveness

The federal student loans also offer several types of up-front loan forgiveness for working in particular occupations, including teachers, volunteer work, health professions, public interest law, government employees and military service.

Other Types of Loan Cancellation

Other types of loan cancelation include bankruptcy discharge, death discharge, total and permanent disability discharge, closed school discharge, false certification discharge (e.g., identity theft), unpaid refunds and spouses/parents of 9/11 victims and public servants.

Bankruptcy Discharge

Bankruptcy discharges are very rare, as both federal and private student loans are excepted from discharge unless repaying the debt will represent an undue hardship on the borrower and the borrower's dependents. Since Congress did not define undue hardship, most courts use either the Brunner test or the totality of circumstances test. The Brunner test involves three prongs:

The borrower cannot maintain a minimal standard of living (e.g., 150% of the poverty line) for the borrower and the borrower's dependents if forced to repay the student loans on the borrower's current income and necessary expenses.

The circumstances that prevent the borrower from repaying the loan are likely to persist for most of the repayment period of the student loans.

The borrower has made a good faith effort to repay the loans, such as using deferments, forbearances, and alternate repayment plans.

The U.S. Department of Education almost always raises the availability of income-based repayment and the total and permanent disability discharge as defenses to bankruptcy discharge. Most cases that involve discharge of federal student loans involve high dependent care costs for a special needs child or elderly parent, high ongoing medical and disability-related costs that don't qualify for a total and permanent disability discharge (e.g., income above the poverty line), Federal Parent PLUS loans (which are not eligible for income-based repayment) or unusually high debt. Cases that involve discharge of private student loans might also include private student loans that don't offer a disability discharge.

Taxable Loan Forgiveness

In some cases, cancelled debt may be treated as taxable income to the borrower. In such situations, the lender will issue IRS Form 1099-C to report the cancelled debt to the Internal Revenue Service (IRS). For example, if a Federal Parent PLUS loan is cancelled because of the death of the student, if a borrower succeeds in obtaining a total and permanent disability discharge or if the borrower's debt is forgiven after 20/25 years in an income-driven repayment plan, the forgiveness may count as income to the borrower. This effectively replaces the education debt with somewhat smaller tax debt.

If the taxpayer is insolvent, the IRS may allow the taxpayer to exclude all or part of the cancelled debt from income. A taxpayer is considered to be insolvent if total debts exceed total assets. The borrower will need to file IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. Additional information may be obtained from IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments.

If the taxpayer is not insolvent, he or she should submit an offer in compromise on IRS Form 656.