Forgiving a Loan: Can the benefactor deduct interest paid and will they have to report income to the IRS?

James Hamill for ABQJournal writes: Question: My son is 25 years old and just finished his second year at the University of Arizona law school. He has a sociology degree from UA and he worked full time the last two years of his undergraduate studies to pay school expenses not covered by scholarships. We have not claimed his as a dependent since 2009 and he was able to get in-state tuition for law school. But he still has to pay about $25,000 a year for tuition. He still supports himself but when he got to law school we started to loan him money because he could not work as many hours. He now owes us $23,000 in principal, and we are charging 2 percent interest, which starts when he graduates next May. The loan may reach $35,000 by the time he graduates. We expect him to pay us, but he has been dating a girl in Tucson for almost three years and he has told us they expect to get engaged when he graduates. The wedding date may be summer of 2015. If he does get married my wife and I have decided we do not want the couple to be burdened by school loans, so we will forgive the balance of his loan as a wedding gift. I have two questions: Can he deduct any interest that he pays to us and will he have to report income to the IRS if we do forgive the loan?

Answer: He cannot deduct any interest that he pays to you because the loan is considered to be personal in nature. Personal interest is not deductible.

The tax law does allow for a deduction for interest on a “qualified educational loan.” Your son’s loan seems to meet all the requirements except for one – the lender is a related party.

Because the lender is a related party, the special rule for qualified educational loans does not apply and the general rule for personal interest expense will apply.

The tax law does include an economic benefit realized from cancellation of a debt (COD) as income to the borrower. The lender may also be able to claim a short-term capital loss for a bad debt.

However, the COD income/bad debt deduction result generally applies when the lender wants to recover the loan but cannot because the borrower is unable to make timely payments.

Your plan would be to forgive the loan as a wedding gift, which would save your son (and his new wife) from any COD income because gifts are excluded from income.

A gift forgiveness would also mean that there would be no possibility for you to claim a bad debt deduction for a failed loan.