Student Loan Forgiveness: Taxable or Tax-Free? | Review

Student loan forgiveness has been the subject of a lot of recent discussions. 

For instance, a well-liked resolution requests that President Biden take executive action to forgive up to $50,000 of student debt on behalf of all Americans who have borrowed money from the federal government. 

How the Biden Administration will react to calls for implementing a new student loan cancellation policy is still a matter of speculation. 

There are some things to take into account regarding how the forgiveness may affect student loan forgiveness tax liabilities, regardless of whether borrowers receive a loan discharge through new legislation or through an existing program.

It may appear nice to receive a $50,000 cancellation of student loan debt. 

However, you might find that you unexpectedly owe the IRS an additional $10,000 or more (depending on your tax bracket) when you file your next tax return if those forgiven amounts are viewed by the federal government as taxable income. 

Generally speaking, the type of forgiveness you receive will determine whether or not it is tax-free. 

However, recent legislation passed by Congress has temporarily increased the number of people who can get their student loans forgiven tax-free. 

Therefore, you must be aware of the following;

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What Student Loan Forgiveness Options Are Tax-Free Regardless of the Situation?

According to the IRS, if a debt is “canceled, forgiven, or discharged for less than the amount you must pay, the amount of the canceled obligation is taxable and you must disclose the canceled debt on your tax return for the year the cancellation occurs.” 

However, there have always been exceptions to the rule, particularly in cases of student loan forgiveness. 

According to 26 U.S. Code 108, for instance, students who enroll in programs that “encourage its students to serve in occupations with unmet needs or in areas with unmet needs” are eligible for a tax-free discharge of their student debt.

Therefore, the majority of schemes forgiving student loans that are industry-specific are not subject to federal taxes. 

This would comprise the Teacher Loan Forgiveness Program, the Perkins Loan Cancellation Program, and the Public Service Loan Forgiveness Program (PSLF). 

Not all loan cancellations, including career-specific cancellations of student loans, are automatically deducted from income on federal tax returns. 

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Dismissals due to shuttered schools, fake certifications, and underpaid refunds are a few further significant occurrences.

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When Does the Forgiveness of Student Loans Become Taxable Income?

The forgiveness that is granted at the conclusion of an income-driven repayment (IDR) plan is the most recognized sort of federal student loan cancellation that may be subject to taxation. 

There are currently four IDR plans:

  • Pay As You Earn (PAYE)
  • Revised Pay As You Earn (REPAYE)
  • Income-Based Repayment (IBR)
  • Income-Contingent Repayment (ICR)

After 20 to 25 years, depending on the IDR plan the borrower joins, the remaining debt will be forgiven. 

The amount left over for forgiveness may be significant if a borrower’s income was very low during that 20 to 25-year payback period. 

Such forgiven sums would often be regarded as taxable income under the present tax laws. 

Federal student loan discharges resulting from death or incapacity, in addition to IDR forgiveness, have generally been treated by the IRS as taxable income.

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Are There Any Current Tax Exemptions For All Federal Student Loan Forgiveness?

Yes, through December 31, 2025, all federal student loan discharges will be exempt from income taxes because of the American Rescue Plan, a policy of the Biden administration that was approved in March 2021. 

With the help of this new exclusion, the federal government’s cancellation of IDRs and all other types of student loans is now tax-free for borrowers. 

Note that death and disability discharges were already tax-free through 2025 because of the Tax Cuts and Jobs Act, which took effect on January 1, 2018.

It’s vital to realize that the new legislation established by Congress only has a direct impact on whether student loan forgiveness is subject to federal taxation. 

You can still be liable for state income taxes on the forgiven debt, depending on where you live. 

While the definition of “adjusted gross income” (AGI) as used by the federal government is adhered to by the majority of states that levy state income tax, certain jurisdictions do not. 

To find out more about how student loan forgiveness may affect your state tax payment, check with the department of revenue in your state or get advice from a tax expert.

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How Does the Taxability of Student Loan Forgiveness Affect Insolvency?

The tax ramifications of your student debt forgiveness can be mitigated by one more circumstance, namely insolvency. 

Many years ago, the IRS tax code included a provision known as the “insolvency rule” that covered any canceled debt, not only student loans. 

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According to the IRS, borrowers are deemed insolvent if their entire liabilities exceed the total fair market value (FMV) of all of their assets, and this insolvency may result in a reduction or, in some situations, a total elimination of the tax liability associated with the debt cancellation.

Borrowers who just got debt cancellation are given an insolvency worksheet by the IRS. 

List all of your debts, including credit card balances, vehicle loans, personal loans, student loans, etc., as well as the FMV of your existing assets to complete the form (bank accounts, retirement accounts, tangible assets, etc.). 

For example, if your total liabilities are $50,000 and your assets total $25,000, you are $25,000 insolvent. 

Let’s imagine your college loans are canceled and you receive a payment of $20,000. 

The entire amount would be excluded from your taxable income because your pre-cancellation insolvency ($25,000) is higher than the amount canceled ($20,000).

However, let’s adjust the scenario from the prior example and suppose that your student loans, which make up $40,000 of your obligations, are canceled as a whole. 

Since you cannot deduct more than the amount for which you are insolvent, in this instance, $15,000 of the cancellation must be included in your taxable income.

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What Are The Tax Implications Of Biden’s Student Loan Forgiveness? 

A clause stating that all student loan forgiveness is tax-free was included in the American Rescue Plan, which Biden signed into law in March 2021. 

Despite the possibility that any applicable federal income taxes on forgiven student debt may not be eliminated, it is still possible to be subject to state income tax obligations based on the amount of forgiven debt. 

You might think about saving some money for tax season if that is the case. 

The forgiven debt is often taxable in other situations, though.

Typically, it is well informed that when a debt, whether it be student loans or another type, is forgiven, the amount forgiven typically constitutes taxable income in the year it is written off, according to Steven Rossman, CPA, shareholder at Drucker & Scaccetti, a tax-focused accounting firm with offices in Philadelphia. 

Rossman provides a $10,000 federal student loan forgiveness as an illustration of how that amount would have been taxed in the past before Biden’s tax update. 

Consider the scenario where $10,000 of your federal student loan debt is forgiven in 2022. 

As a result, you would receive a Form 1099-C for 2021 as proof and $10,000 would be added to your taxable income as “Cancellation of Debt (COD)” revenue.

When it comes time to file your 2022 tax return (in April 2023), you will have $10,000 to include as COD income. 

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If you are in the 20% federal tax bracket, for instance, this will result in an extra tax of $2,000 ($10,000 x 20%), which is due in April 2023 when 2022 taxes are filed. 

Notably, individual tax rates will change. 

The borrower would owe $2,000 in taxes, according to Rossman. 

The good news is that they are not required to repay the loan in full, which is $10,000.

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What Happens When Student Loan Forgiveness is Tax-Free?

Prior to Biden’s signing the American Rescue Plan into law, there were only a few circumstances in which student loan forgiveness may be taxed. 

According to Finaid.org, if the forgiveness is conditional upon the borrower working for a set period of time in a specific profession, like with Public Service Loan Forgiveness, it may be excluded from taxable income (PSLF). 

The IRS website lists further exclusions from taxable canceled debt. 

Prior to Biden’s tax update, Rossman had hypothesized that the pandemic’s unique circumstances would have caused extra exclusions to be made for borrowers of student loans.

According to him, if a loan is used for an acceptable business expense, it is not taxable to the business owner, as has been demonstrated by debt forgiveness under the Paycheck Protection Program (PPP). 

Perhaps this will serve as a precedent for the taxability of forgiven student loan debt.

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Conclusion

Through 2025, all student loan discharges and forgiveness are exempt from federal income taxes. 

What happens, though, if you only recently enrolled in an IDR plan and won’t be qualified for forgiveness for another 10, 15, or 20 years or more? 

There is a potential that the IRS will treat whatever forgiveness you obtain in these circumstances as taxable income. 

You have plenty of time to make plans, which is fantastic news and the earlier you start saving for a potential “tax bomb,” the simpler it will be to do so without breaking the bank. 

Consider that you anticipate paying $5,000 in taxes on the $50,000 in forgiveness that you anticipate receiving in 16 years.

You would only need to set away roughly $26 every month if you began saving immediately. 

Additionally, borrowers should keep an eye on any changes to the law governing student loans, particularly between now and 2025. 

Before the interim provisions expire, Congress may take action to permanently eliminate taxes on student loan forgiveness.

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