Will Bankruptcy Automatically Wipe Out That Student Loan?

Will Bankruptcy Automatically Wipe Out That Student Loan?

By |August 17th, 2014|

Bankruptcy won’t wipe out a student loan without some additional work. Unless it’s not a student loan at all.

If you’re dealing with student loan debt, you probably already know that they are usually exempt from discharge in a bankruptcy case. In fact, getting your student loans wiped out in bankruptcy requires an additional determination by the judge.

But what if the loan you consider to be your student loan … isn’t one at all?

How Student Loans Are Treated In Bankruptcy

When you file for bankruptcy, certain debts will follow you after the case is over. Under the law, one of those categories of debts is what’s called and educational benefit – commonly known as student loans.

In fact, there are three categories of student loans that are exempt from discharge. They are:

  1. an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution;
  2. an obligation to repay funds received as an educational benefit, scholarship, or stipend; or
  3. any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual.

Governmental Units And Nonprofit Institutions. This one is simple: if we’re dealing with a federal or state loan, it’s not discharged in bankruptcy.

And if the program that issues the loan is funded in whole or in part by the government or a nonprofit institution, it’s not discharged in bankruptcy.

This also includes any overpayment of a benefit, such as a scholarship or grant that contains a provision requiring you to repay the funds if the entity disburses too much.

Educational Benefit, Scholarship, or Stipend. Let’s say you get a stipend as part of a graduate or undergraduate degree. If you don’t live up to your part of the bargain, usually by way of not performing academically or professionally. The terms of the stipend will usually include a provision that demands repayment of the monies paid or tuition forgone. That’s not discharged in bankruptcy.

So, too, if you’re the beneficiary of a scholarship that requires you to perform in some fashion – either by maintaining a certain grade point average, playing on a team, or graduating with a certain course of study.

Qualified Education Loan. This is the biggie, folks. Let’s say you got a loan to go to college. It’s a private loan, taken from a bank and not clearly stated to bean educational loan. If the IRS doesn’t consider it as a qualified education loan, you’re home free.

The IRS Definition Of A Qualified Education Loan

Under Section 221 of the Internal Revenue Code, a qualified education loan is any debt incurred by the taxpayer solely to pay qualified higher education expenses so long as that debt satisfies the following three criteria:

  1. the debt was incurred on behalf of the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer as of the time the indebtedness was incurred; AND
  2. the higher education expenses were incurred within a reasonable period of time before or after the indebtedness is incurred; AND
  3. the expenses are attributable to education furnished during a period during which the recipient was an eligible student.

The IRS specifically states that a debt owed to a person who is related to the taxpayer is not considered a qualified education loan. Nor is a loan taken against your pension or retirement plan considered a qualified education loan.

Guarantors And Cosigners Rejoice?

Notice that the IRS specifically states that the loan must be made on behalf of a taxpayer, taxpayer’s spouse, or a dependent of the taxpayer to be considered a qualified education loan.

Relatives and others who guarantee or cosign a loan for a student who is not a spouse or dependent may end up being able to jump through a loophole. That is, if the Note doesn’t specifically state that the loan is for educational purposes.

Not So Simple

Most student loans will fall neatly into one of the categories that keeps them from being automatically wiped out in bankruptcy. After all, private lenders are usually too smart to let their debts get wiped out.

But for some people, the loophole of getting a student loan discharged in bankruptcy may magically appear. The important thing to remember is to always review the loan papers with a keen eye.

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About the Author:

I've been a consumer protection lawyer since 1995, working to help people end their bill problems. I'm a faculty member at the Student Loan Law Workshop, a nationally recognized speaker, and a long-time member of both the National Association of Consumer Bankruptcy Attorneys and National Association of Consumer Advocates.