It’s that time of year, and Americans are gearing up to start filing their taxes. But for millions of student loan borrowers, the landscape is more confusing than ever.
Borrowers who are in repayment, have received student loan forgiveness, or are on track for eventual discharge have a complex array of rules, opportunities, exceptions, and pitfalls to navigate. And it’s important to obtain competent tax advice from a qualified professional, such as a Certified Public Accountant.
Here’s what student loan borrowers know.
Student Loan Forgiveness Not Taxable Federally, But Could Be In Some States
Typically, the cancellation of any debt can be a taxable event. Borrowers would be issued a Form 1099-C, which requires them to report the discharged debt as income for tax purposes.
Under current law, however, most forms of federal student loan forgiveness are not taxable federally through the end of 2025. Certain programs, such as Public Service Loan Forgiveness and Teacher Loan Forgiveness, have always been tax-free under federal law. For other programs, such as Income-Driven Repayment plans (which can provide loan forgiveness after 20 or 25 years in repayment), the American Rescue Plan Act of 2021 temporarily exempts discharges from federal taxation.
“The American Rescue Plan Act included a provision temporarily modifying the tax treatment of discharged student loan debt,” says Education Department guidance. “Specifically, the law excludes from gross income qualifying student loans that are discharged between Dec. 31, 2020, and Jan. 1, 2026. During this period, the amounts of forgiven student loan debt won’t be subject to federal taxation.”
But the department warns that despite the federal tax exemption for student loan forgiveness, some states may still consider such discharges as income for state tax purposes. “You won’t get taxed by the federal government, but your state government might tax you,” says the department.
Borrowers should consult with their tax advisor regarding any state tax liability associated with federal student loan forgiveness. Failure to comply with state law could result in penalties.
Plan For Student Loan Forgiveness Being Taxable Again After Next Year
The Biden administration has approved more than $130 billion in student loan forgiveness so far. Other borrowers may not qualify for immediate relief, but could receive significant retroactive credit toward loan forgiveness under the IDR Account Adjustment initiative. This could shorten their remaining time in repayment, and accelerate their loan forgiveness timeline.
But for borrowers who are set to receive IDR loan forgiveness sometime after 2025, discharges could revert to being taxable again. Congress could potentially extend or make permanent the current federal tax exemption set to expire on January 1, 2026, and doing so could be a rare opportunity for bipartisan agreement. But if that doesn’t happen, many borrowers could be facing significant tax bills sooner than expected.
Student loan borrowers should keep an eye out this summer for the publishing of IDR payment counts, which the Education Department says will be released in July under the IDR Account Adjustment. Formal IDR payment counts will give borrowers a clearer sense as to when they might reach the 20- or 25-year milestone for student loan forgiveness. Then, borrowers should consult with a tax or financial advisor and create a plan to address potential taxation on the discharged balance. Failure to adequately plan for an unexpected tax liability could have significant consequences.
One Student Loan Forgiveness Program Could Have Serious Implications For Taxes
While student loan forgiveness is generally non-taxable federally through the end of 2025, one program is a bit more complicated.
The Total and Permanent Disability discharge program can eliminate the federal student loan debt for borrowers who are unable to maintain substantial, gainful employment due to a medical condition. Borrowers who are approved for a TPD discharge based on a medical provider’s certification or receipt of Social Security disability benefits are subject to a three-year post-discharge monitoring period, during which the forgiven loans can be reinstated under certain circumstances (such as returning to school and taking out a new federal student loan).
The Education Department’s stated position is that even though student loan forgiveness is not taxable through the end of 2025, borrowers could still be taxed on TPD discharges because the government does not view the discharge as complete for tax purposes until after the three-year monitoring period ends.
“You’re considered to have received the discharge for federal tax purposes at the end of the post-discharge monitoring period,” says the department on its website.
Borrowers who were approved for a TPD discharge in 2023 would not complete their three-year monitoring period until 2026. That means that they could receive a 1099-C in 2027 (for tax year 2026) if Congress does not extend the current temporary tax relief.
Many TPD discharge-eligible borrowers will still not have to pay taxes on their forgiven student loan balance if they qualify for other tax exemptions, such as insolvency. But it would be prudent for individuals who received a TPD discharge in 2023 or later to consult with their tax advisor. Failure to do so could result in some big surprises in a few years.
See the article here.
By Adam S. Minsky, Senior Contributor at Forbes
Published February 9th, 2024