Deducting Interest If You Settled A Private Loan

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As more and more borrowers realize that private student loan settlement is the closest existing thing to private student loan forgiveness, settlement is being utilized more often as a way to pay off defaulted loans. Settlement is not easy. It is most often an adversarial process, and lenders would much rather get you back on a payment plan so they can make money off of the interest you pay over the life of the loan. However, settlement is possible through extensive negotiations. We’ve mentioned before that it often makes sense to hire a professional negotiator and/or certified professional who has extensive experience negotiating private student loan debt. There are caveats to settlement, and pros and cons to be weighed.

For instance, for borrowers who are current, going late to settle can be a valid strategy – although no company or advisor should ever tell someone to default. A strategic default is a highly personal decision that should be made without influence or bias from an advisor or third party company, after the borrower becomes fully informed of the risks involved. We’ve often mentioned extensive credit damage as the hefty price borrowers who are current must pay, should they choose to go late in order to strategically default. Another issue for many borrowers who settle, whether they strategically default or not, is the possibility of being taxed on the amount they save as if it were additional income. Luckily, this usually only happens if borrowers are financially solvent at the time of settlement – meaning they have more assets than debts (including the debts being settled). Many borrowers, especially those settling six figure private student loan balances, are going to be in the insolvent category and may not have to pay any taxes on the amount saved. However, tax advice is not something I am licensed to provide, so I always tell my clients to talk with a CPA or tax professional prior to settlement in order to get an idea of what their tax liability will be, if any. 

What many borrowers don’t know is that there is an upside to settling their private student loans as well, in terms of tax liability. According to the IRS, the 1098-E form is issued to borrowers who have paid more than $600 in interest to their loan servicer or lender over the previous year. In many cases, lenders allocate reduced sum settlement amounts to a portion of the principal and also a portion of the accrued interest. The amount deducted from income subject to tax can be up to $2500, which can make a big difference on your tax bill. You will receive tax documents such as the 1099-C or 1098-E directly from your lender – so if you’ve settled with a collection agency who is working on behalf of the lender, keep in mind that these statements will only come from the lender themselves. Lenders should automatically send you this within a couple months after settling; but if they don’t, you’ll want to be proactive and reach out to the lender yourself.

Another thing to keep in mind is that if you’re doing a structured settlement, the 1098-E would be issued the year that you make the last settlement payment on the structured settlement in most cases; unless you’re paying a large amount in structured settlements payments prior to the settlement being paid off. In that case, your payments may equal or exceed the $600 minimum threshold the IRS requires – but it all depends on how your private student loan lender is allocating your structured settlement payments. If they consider the settlement to be just a portion of the principal, and they consider the forgiven amount to include all of the accrued interest, then no 1098-E would be issued. However, some of my recent settlement clients did receive 1098-E’s for the full $2500 maximum deductible after settling accounts for between 40-50% of the balance. The picture at the top of the article is an actual 1098-E from one of my recent clients.

You’ll want to talk to your lender, and possibly even conference in your tax professional or CPA, to determine whether or not you will receive a 1098-E after settlement. For those who do, it can help offset any taxes on the amount saved and provide an extra benefit to settling their private student loan debt. This is only available on private student loan settlements – not credit card settlements – although the same perk is available if borrowers pay more than $600 in interest on their federal student loans as well. 

Be sure to check out our federal loan resource page for guides and information on dealing with your federal loans, and if you have private loans that you’d like to settle, I can help you settle them for the lowest possible amount – while making sure the settlements are executed properly. 

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About Andrew Weber, NACCC Certified Student Loan Counselor

Andrew Weber is a NACCC Certified Credit Counselor and a NACCC Certified Student Loan Counselor. He is the only certified student loan Counselor who specializes exclusively on private student loan issues in the US. He's helped hundreds of borrowers drastically reduce their debts.