New Jersey Woman's Student Loan Debt Creates Tax Nightmare

April 6, 2012 — -- When Kim Thompson's $91,000 student loan balance was cancelled due to total disability, she thought she had put at least one of her problems behind her. Instead, she traded it for another: a massive debt to the IRS.

Two years ago, Thompson, who lives in New Jersey, was diagnosed with a tumor that eventually led to the removal of most of her small intestine, a pulmonary embolism, and 12-hour-a-day IV feeding sessions. She retired from her job on a disability pension in July 2010, and was able to get her federal student loans cancelled.

There was no mention, however, that the debt would be reported to the IRS as Cancellation of Debt Income (CODI).

"They didn't tell me it was taxable income," she says. "I had no idea."

The IRS considers most types of cancelled debt taxable income. Lenders must report cancelled debts of $600 or more to the IRS on a 1099-C form. The IRS estimates some 6.3 million 1099-C's – for all types of debts, including student loans, credit cards, mortgages, etc. – were filed this year reporting CODI for the 2011 tax year.

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Not all cancelled student loan debt is taxable. If Thompson's debt had been forgiven because she worked in a job that qualified her to have some or all of her debt wiped out (certain medical, teaching or law enforcement positions, for example) she wouldn't now owe the IRS some $26,000. In addition, she owes $5,000 to the state of New Jersey for cancellation of debt income.

But there is no tax break for student loan debt that has been cancelled due to disability, despite the fact that borrowers who qualify for cancellation are considered totally and permanently disabled, and may never work again. In fact, the Department of the Treasury has specifically stated that student loans cancelled due to the Death and Disability Discharge (Section 437(a) of the Higher Education Act of 1965) are taxable.

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Another option, the insolvency exclusion, which requires debtors to be insolvent immediately prior to the discharge, may have allowed her to avoid paying taxes on some or all of the $91,000 of CODI. Thompson's accountant concluded she did not qualify, though she's has some doubt as to whether that's true.

"The (IRS) forms are incredibly confusing," she notes.

As a former social worker with a Master's degree, Thompson says she's not intimidated by government forms. She filled out all her paperwork to file for disability on her own, for example. However, even though she spent hours researching the rules surrounding cancellation of debt income, she found no relief for her situation. She tried calling the IRS for assistance. The first time she called, she says the IRS representative hung up on her. The second time, she says she waited on hold for over an hour and was then told to call back after she filed her tax return. She claims that ultimately she was warned that if she couldn't pay the amount due, the IRS would put a tax lien on her house and report her to the credit reporting agencies. (We've reached out to the IRS a number of times on this and other issues relating to the 1099-C, but to date haven't gotten a response.)

[Related Story: A Slew Of Tax Tips To Clean Your 1099-C Mess]

Thompson isn't the only one who has been struggling with this issue. A reader, Debbie, recently commented on the Credit.com blog: