Is Student Loan Forgiveness Tax-Free?
Congress recently made all student loan forgiveness tax-free through 2025. But debts cancelled in 2026 or later could still trigger a tax bill. Learn more.
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There's been a lot of discussion lately about student loan forgiveness. One popular resolution, for example, calls for President Biden to use executive action to cancel up to $50,000 of student debt for all U.S. student loan borrowers.
It's still unclear how the Biden Administration will respond to the pressures to introduce a new student loan cancellation policy. But whether borrowers receive a loan discharge through new legislation or through an existing program, it's important to consider how the forgiveness could impact their tax liability.
Receiving $50,000 of student loan cancellation might sound wonderful on the surface. But if those forgiven dollars are considered taxable income by the federal government, you could find that you suddenly owe an extra $10,000 or more (depending on your tax bracket) to the IRS on your next tax return.
Whether or not student loan forgiveness is tax-free usually depends on the type of forgiveness that you receive. But recent legislation from Congress has temporarily expanded the availability of tax-free student loan forgiveness. Here's what you need to know.
What Types of Student Loan Forgiveness Are Always Tax-Free?
The IRS says that, as a general rule, if debts are: "Canceled, forgiven, or discharged for less than the amount you must pay, the amount of the canceled debt is taxable and you must report the canceled debt on your tax return for the year the cancellation occurs."
But there have always been exceptions to this rule, especially when it comes to forgiveness for student loans. For example, 26 U.S. Code § 108 states that when students attend programs that "encourages its students to serve in occupations with unmet needs or in areas with unmet needs," their student loans can be discharged tax-free.
This means that most occupation-specific student loan forgiveness programs are federally tax-exempt. This would include the Public Service Loan Forgiveness Program (PSLF) program, the Teacher Loan Forgiveness Program, and Perkins Loan Cancellation.
Profession-specific student loan cancellation isn't the only type of forgiveness that's automatically excluded from income on federal tax returns. Other notable exceptions include closed school discharges, false certification discharges, and unpaid refund discharges.
When Can Student Loan Forgiveness Be Considered Taxable Income?
The most notable type of federal student loan cancellation that could be taxable is forgiveness that's received at the end of an income-driven repayment (IDR) plan. Currently, there are four IDR plans:
- Pay As You Earn (PAYE)
- Revised Pay As You Earn (REPAYE)
- Income-Based Repayment (IBR)
- Income-Contingent Repayment (ICR)
Depending on the IDR plan they join, borrowers will receive forgiveness on any remaining balance after 20 to 25 years. If a borrower's income was relatively low during that 20- to 25-year repayment period, the amount left over to be forgiven could be substantial.
Under current tax rules, such forgiven balances would normally be considered taxable income. In addition to IDR forgiveness, federal student loan discharges due to death and disability have been historically viewed as taxable income by the IRS.
Is All Federal Student Loan Forgiveness Currently Tax-Free?
Yes, the Biden Administration's American Rescue Plan, which passed in March 2021, included an income tax exclusion for all federal student loan discharges through December 31, 2025.
This new exclusion makes IDR forgiveness tax-free as well as any other type of student debt cancellation that a borrower may receive from the federal government. Note that the Tax Cuts and Jobs Act (which went into effect January 1, 2018) had already made death and disability discharges tax-exempt through 2025.
It's important to understand that the new laws passed by Congress only directly influence the federal taxability of student loan forgiveness. Depending on where you live, you may still owe state income taxes on the cancelled debt.
While many states that charge state income tax do conform with the federal government's definition of adjusted gross income (AGI), some don't. Check with your state's Department of Revenue or consult with a tax professional to learn more about how student loan forgiveness could impact your state tax bill.
How Can Insolvency Reduce the Taxability of Student Loan Forgiveness?
There's one additional exception that can lessen the tax consequences of your student loan forgiveness — insolvency. The "insolvency rule" has been a part of the IRS tax code for decades and applies to all cancelled debt, not just student loans.
When borrowers have total liabilities that are higher than the total fair market value (FMV) of all their assets, the IRS considers them to be insolvent. And this insolvency can reduce or, in some cases, completely eliminate the tax liability of their debt cancellation.
The IRS provides an insolvency worksheet for borrowers who recently received debt cancellation. To complete the worksheet, you'll need to list all of your debts (credit cards, auto loans, personal loans, student loans, etc.) and FMV of your current assets (bank accounts, retirement accounts, tangible assets, etc.).
Let's say that you have $25,000 in assets and $50,000 in total liabilities, making you insolvent by $25,000. Next, we'll say that you receive $20,000 in student loan cancellation. Since your insolvency before cancellation ($25,000) was higher than the amount cancelled ($20,000), the entire amount would be excluded from your taxable income.
But let's make one change to the example above and assume that $40,000 of your liabilities are student loans and you receive cancellation for the entire amount. In this case, $15,000 of the cancellation must be included in your taxable income since you can't exclude more than the amount that you're insolvent. Here's the calculation:
$40,000 (cancelled debt) - $25,000 (insolvency amount) = $15,000 of taxable income
In these cases, there's certainly a chance that any forgiveness you receive at that time could be considered taxable income by the IRS. The good news is that you have a long time to plan. And the earlier that you begin saving for a future "tax bomb," the easier it will be to do so without causing a strain on your budget.
Let's say you plan to receive $50,000 of forgiveness in 16 years and expect that you'll owe approximately $5,000 of taxes on the forgiven amount. If you started saving today, you'd only need to set aside about $26 per month.
Borrowers should also continue to monitor future student loan legislation, especially from now until the end of 2025. It's very possible that Congress could move to make student loan forgiveness permanently tax-free before the temporary provisions expire.