If you allowed forgiven debt to be untaxable, we could all pay each other in forgiven loans and avoid the IRS entirely!
A recent heartbreaking story in the paper (which of course, tells only one side of the story) concerns a disabled vet who went to Cooley Law School and ran up a quarter-million dollars in student loan debt. I will refrain from commenting about Cooley Law School as they have sued people in the past who have discussed their operations. The Wikipedia link cited above, if read carefully, tells the whole story.
Sadly, this story is repeated time and time again in America, where we are told that a college education - any college education at any college in any field of study - is a one-way ticket to riches. It isn't. Even in the lucrative fields of Engineering and Patent Law (well, at least at the time I was in them) it was a ticket to a comfortable middle-class lifestyle, and certainly not worth $250,000 in student loans, even today.
For people majoring in "Sociology" or "International Law" or other nebulous fields? People who attend "for profit" or bottom tier schools? For them, college and grad school can be worse that worthless - the staggering cost and lifetime loan commitments mean the student sells off the rest of his working life for a few years of "study" that never leads to gainful employment. It simply isn't worth it.
There are better fields to study, and cheaper ways to go about getting a degree. Spending $60,000 a year on college is just plain dumb - no matter what your major is. Sorry, but that's the God's Honest Truth about it. I worked my way through college - all 14 years of it - and graduated with a lot less than $250,000 in debt. Plus I had a job when I graduated - the same job I had before I graduated!
But I feel bad for this guy, because like so many before him, he answered the siren song of college and law school, sold on the idea that if he borrowed enough money, he would end up with this credential that would guarantee him a high-paying job. The problem is, the jobs were never that high-paying to begin with and then the bottom fell out of the legal market about eight years ago.
Now he's on full disability and his law degree is pretty worthless to him.
Oh, it's not all bad news, of course. There are still lawyers - with experience - who are finding jobs and employment. They aren't making the big bucks that you see on television law shows, however. It is a much more competitive business than before. And as I noted before, "If you are in it for the money, you will never be happy, but if you do it because you love it, the money doesn't matter."
And sadly, a lot of people get into fields such as Engineering, Medicine, Law, and so forth, convinced they will make a lot of money, when in fact, the best they can hope for is a nice comfortable middle-class existence and a career that is interesting and rewarding.
That ain't such a bad thing, is it?
But I digress.
What is shocking - at least to some folks - is that after this fellow had his quarter-million-dollar loan debt cancelled, he was sent a bill by the IRS and the Michigan Department of Taxation for taxes due on this loan forgiveness. Since this $250,000 "payday" puts him in the highest brackets, he owes about 40% of the loan amount as income tax- and a smaller amount to the State as well.
To some folks, this makes no sense, or at the very least, seems unfair. The poor guy can't repay his loans on a disability income, so there is no way he can pay the taxes on it, either.
Perhaps a payment plan can be worked out with the IRS to pay the debt in installments over a number of years. Maybe the government will come up with a new law exempting people on disability from this tax. Hell could also freeze over, too.
But while it may be unfair to tax a disabled person this way, the underlying premise of the tax code in taxing forgiven debt isn't anything new or anything shocking. If we allowed "forgiven" debt to be untaxed, it would not take long for everyone to be paying each other in forgiven loans.
For example, suppose you wanted to pay me a million dollars. That would knock me into the highest brackets and I would end up paying the IRS and the State over $400,000 in taxes or thereabouts. I suppose we could form a Subchapter-S corporation or something and I could pay myself in dividends or deferred interest as Mitt Romney and Donald Trump do. That might knock me down to 25% or even 15% capital gains rates, if we structured it right.
But suppose instead, you loaned me the million dollars and then said, "I forgive the loan!" Since one doesn't don't pay taxes on loans (because, despite what poor folks think, getting a loan is not like getting free money) I don't have to pay taxes on the million bucks, right?
Well, the IRS and the United States Government are not that dumb. That loophole was closed a long time ago and Publication 4681 explains how this works. And if you think about it, there are logical reasons why this law is in place. A loan forgiven is income, because your net worth just jumped up by the amount of the debt that was wiped out.
Now granted, this can have unintended consequences - most sections of the tax code do. For example, you buy an investment property for $250,000 and then proceed to remortgage it over the years, adding to the balance of the loan. A decade later, you now owe $500,000 on the mortgage, having "taken out" cash at closing in a series of serial refinances. You also have depreciated the property on your taxes, reducing your income tax each year. But now your "adjusted basis" in the property is zero dollars.
You sell the property for $500,000 which barely pays off the mortgage. You walk way with no cash. But the IRS (and State tax people) sock you with a capital gains tax of $75,000 or more - 15% of the proceeds. You made no cash on the deal, but you now owe money, which you haven't got.
Now in this case, you would not cry "unfair" because the person with the property made money and just chose to spend it by taking cash out in refinancing. They also got a tax deduction as well. The fact they didn't put some money aside for the inevitable capital gains taxes isn't the fault of the government or the IRS, but themselves.
But of course, we expect an investor to be a little more sophisticated when it comes to finances. Someone investing in real estate should know what they are doing, but of course, the track record of boom-and-bust-and-default-and-foreclosure that has been going on since the 1980's would seem to tell a different story. Americans all think their houses are made of gold and get angry when they find out that sometimes they aren't.
You could make the argument (but I won't) that this disabled vet received a free education worth $250,000 (I question the pricing of the law school, though - that seems awfully pricey!). So he is not simply walking away from debt, he is walking away from something of value he bought. That he overpaid for that "something" isn't really the IRS's problem.
In other words, the IRS isn't being "mean" here but just doing their job. In fact, they have no discretion or choice in the matter. If they chose to "forgive" tax debts, they would be in far more trouble than the bad P.R. they are getting now. Government agencies are not allowed to selectively enforce laws depending on the sympathy of the person or corporation involved (at least in theory, I am sure there are examples where some well-heeled company has managed to bend the law to their will).
Of course, this raises the question, did Donald Trump have to pay taxes on all the forgiven debt he had running his various businesses into the ground? And I suspect the answer is "no" as he was shielded from most of these debts (directly) as they were run through corporations that ran his various projects. The corporations then declare bankruptcy and leave the banks and the IRS hanging.
Too bad law students can't incorporate. Oh, a neat idea, but it won't work. For us "little people" the idea of forming a corporation and then accumulating debt in the corporate name simply won't work. I had three subchapter-S corporations at one time, and two of them had debts, my real estate venture in particular had over a million dollars in mortgage debt.
But a funny thing - in order to obtain those mortgages, we had to personally guarantee the notes, which meant that if the whole thing went belly-up (for example, we didn't sell out in time as we did) we would be on the hook personally for those debts. And if those debts were forgiven, we'd have to pay taxes on the forgiven debt amounts. And yes, some real estate investors caught up in the bubble of 2008 found themselves with tax bills for forgiven mortgage debts. For your own home, however (whose capital gains are largely untaxable) such taxation of forgiven debt may not apply. It gets complicated.
Funny, but if his home mortgage was cancelled, he would have been in the clear. Maybe pay for school with a home equity loan instead? That does require you have a home, however, as well as equity in it.
I hope the poor fellow in the article finds some sort of relief from the taxes due. Perhaps he needs to declare bankruptcy, as painful as that sounds. Expecting Congress to act and pass a retroactive bill seems kind of farfetched, given how little Congress gets done these days.
But the idea that taxes are due on cancelled debt is "a weird area of law" as one person opined in the article or that it "makes no sense" as another noted, it just naive. Cancelled debt is clearly income - you are receiving a monetary benefit that increases your net worth by the cancelled amount and relieves you from paying back the balance of the loan. While it may not put cash in your pocket, it is income, no matter how you slice it.
Whether this is "fair" in certain circumstances, is another question.