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Better to skip your mortgage payments than make your student loan payments.

October 30, 2008

David Plotinsky used student loans to help pay his way through law school. After graduating he consolidated his loans with an outfit that promised to forgive a chunk of his debt if he made 36 consecutive payments on time.

Mr. Plotinsky held up his end of the deal, and the lender knocked $3,043 off the loan balance. The lender also kept up its end of the deal to the IRS, reporting the $3,043 as debt forgiveness income on Form 1099-C.

Mr. Plotinsky didn't report the income on his 1040. The IRS noticed, and he ended up in Tax Court, where he argued that the forgiveness was a gift, rather than taxable income. Predictably, the Tax Court disagreed, finding that the forgiveness was an inducement by the loan company to consolidate his loans with them, rather than "disinterested generosity."

That's the right result as a matter of tax law. Still, it grates. If you stop paying your home mortgage on time and the lender gives up on you, up to $2 million of the debt-forgiveness will be tax-free. But if you get a reward for actually living up to your contract by making your student loan payments, hello IRS.

Cite: Plotinsky, T.C. Memo. 2008-244

UPDATE: The TaxProf has more.

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