With federal student loan payments set to resume Sept. 1, the nonprofit Tax Foundation is once again raising the question of whether borrowers will face a tax hit if their debts are forgiven.
Student loan repayments are starting again after the U.S. Supreme Court struck down President Biden’s student loan debt forgiveness plan in June. While the forgiveness aspect of the administration’s plan was struck down, the foundation noted that President Joe Biden also expanded income-based repayment options and made the rules more generous in rules expected to take full effect by July 1, 2024.
Since the tax code handles debt forgiveness differently depending on the borrower’s qualification for a repayment plan—which survived the Supreme Court decision—more borrowers will be able to have their loans forgiven at the end of a repayment term, the foundation says.
But that “creates a new, potentially complicated tax implications for borrowers, as the forgiven debt can be treated as taxable income in some cases,” authors Arnav Gurudatt, Garrett Watson, William McBride said in the new report.
Among the changes, the new rules increase the amount of discretionary income required before making payments in an income-driven repayment (IDR) plan from 150% to 225% of the federal poverty level ($12,880 in 2023). The rules also reduce the minimum payment from 10% to 5% of discretionary income, they said.
“The changes would likely increase the share of borrowers who receive automatic forgiveness of their outstanding balance at the end of the loan term ... increasing the number of borrowers who run into a tax bill when these loans are forgiven,” the authors added.
Right now, the tax code treats forgiven or canceled debt as taxable income, with some exceptions. Generally, a borrower is provided a 1099-C tax form when debt is canceled or forgiven, which reports the forgiven amount as taxable income to the IRS and the taxpayer, according to the Tax Foundation.
“If a borrower has debt forgiven, it is treated as if the borrower earned additional income in the previous tax year equal to the amount of forgiven debt. For example, if a borrower with an annual taxable income of $35,000 owes $20,000 in debt that is subsequently forgiven or canceled, the $20,000 in debt is added to their taxable income for a total of $55,000,” the authors said.
Currently, “federal student loans forgiven under income-driven repayment (IDR) plans are typically treated as taxable income. Forgiveness under the plans is common because the borrower makes monthly payments based on their income, which may be less than the amount of interest accrued each month. The borrower’s loan balance under the plan may grow over time until the debt is forgiven, which usually occurs after 20 or 25 years of on-time payments,” the authors said.
But there are also exceptions in the current tax code, the authors said. For instance, the “American Rescue Plan Act (ARPA) of 2021 “temporarily exempted student loan forgiveness under IDR plans from federal taxation through 2025 under the rationale that a tax burden arising from treating forgiven student debt as income partially undermines debt relief,” they added.
As an added twist, while ARPA exempts discharged student debt from taxation federally, the discharged debt is still “likely subject to state income tax in several states,” the authors noted.
As of 2023, Indiana, North Carolina, and Mississippi treat forgiven student loans as taxable income, while several other states are determining whether they will do the same, the said.
Other possible tax exemptions from tax include borrowers working at nonprofit organizations or in the public sector, if they’re approved as forgiven under the Public Service Loan Forgiveness (PSLF) program, they added.
Also noteworthy, Tax Cuts and Jobs Act (TCJA) of 2017 gave borrowers with a disability that made it impossible for them to work an exemption from income tax, but that exemption is set to expire after 2025, the authors said.
Far more sweeping, The Student Tax Relief Act which lawmakers have introduced in Congress would permanently exclude all canceled student debt from tax, without changing the tax treatment for lender, they noted.
“The Act would include student debt carried by up to nine million borrowers enrolled in income-driven (IDR) plans who owe $530 billion—more than half of federal student loans in repayment as of 2020,” the authors said.
Alternatively, the IRS could choose to classify forgiven student loans as qualified scholarships, as they did prior to 1973, making student debt cancellation non-taxable like other types of scholarships, they added.
“Moving forward, policymakers must weigh the benefit of expanding tax exemptions for forgiven student loan debt against the complexities and inequities created in the tax base if lenders get write-offs and a select group of borrowers get exclusions.
“From the standpoint of tax simplicity and neutrality, the rules regarding the tax treatment of forgiven loans should be consistent and broadly applied, rather than fragmented and preferential,” the authors concluded.