Borrowers who benefit from President Biden’s student loan forgiveness plan may be subject to taxes in some states because of the debt cancellations, according to the Tax Foundation, a nonprofit Washington, D.C., think tank.
“Under current law, the tax code handles debt forgiveness differently depending on the borrower’s repayment plan—canceling student loan debt would have new, potentially complicated tax implications for borrowers,” said senior policy analysts at the think tank in a blog post they wrote in late August. The authors included Garrett Watson, William McBride and Arnav Gurudatt.
Recipients of the debt forgiveness may get a pass on the federal tax level, but they may in some cases be subject to state income tax, the analysts said.
“As it stands, it appears that most borrowers will be exempt from federal tax on this round of debt forgiveness,” they said. “However, the discharged debt is likely subject to state income tax in several states.”
States that look like they could tax loan forgiveness are Arizona, Connecticut, Hawaii, Idaho, Illinois, Iowa, Kentucky, Massachusetts, Minnesota, Mississippi, New Jersey, New York, Pennsylvania, South Carolina, Virginia, West Virginia and Wisconsin, the think tank said.
Biden’s plan wipes up to $10,000 of student loan debt off the books for borrowers who earn less than $125,000 per year (or couples who earn less than $250,000). Pell Grant recipients, meanwhile, would have up to $20,000 of debt cleared.
“Under current law, the tax code treats forgiven or canceled debt as taxable income, with some exceptions,” the Tax Foundation bloggers said. “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.”
They took an example of a borrower who has $35,000 in annual taxable income. If this borrower also owes $20,000 in debt, which is later forgiven, that amount goes toward their taxable income. The total ends up being $55,000. “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,” the Tax Foundation bloggers noted.
When student loans are now forgiven under income-driven repayment (IDR) plans, said the bloggers, the amounts are typically treated as taxable income. But “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 actually grow over time until the debt is forgiven, which usually occurs after 20 or 25 years of on-time payments,” the bloggers wrote.
The American Rescue Plan Act of 2021 “temporarily exempted student loan forgiveness under IDR plans from federal taxation through 2025 under the rationale that [the] tax burden arising from treating forgiven student debt as income partially undermines debt relief,” the bloggers said.
Recent legislation coming out of Congress, they said, has suggested that tax could also be exempted in other circumstances when debt is forgiven. For instance, the Tax Cuts and Jobs Act of 2017 exempted forgiven student loan debt if it was forgiven under the Total and Permanent Disability Discharge program. That program expunges federal student loan debt when a medical condition keeps a borrower from working.
Another lawmaker proposal, the Student Tax Relief Act, “would permanently exclude all canceled student debt from tax without changing the tax treatment for lenders,” the blog said.
“Alternatively, the IRS could classify forgiven student loans as qualified scholarships, as they did prior to 1973, making student debt cancellation non-taxable like other types of scholarships,” the think tank authors said.
“From the standpoint of tax simplicity, the rules regarding the tax treatment of forgiven loans should be consistent and broadly applied, rather than fragmented,” they said.