Last week we shared with you some of the frightening statistics about student loan debt in this country. Today, Americans owe a combined $1.4 trillion dollars on their student loans. Many of these borrowers are counting on some form of loan forgiveness to help them.
Indeed, certain circumstances might lead to your loan debt being forgiven, canceled, or discharged. Before going into detail, some definitions will be helpful.
The US Department of Education uses the following terms and definitions:
- “Loan cancellation” and “loan forgiveness” generally refer to the cancellation of your obligation to repay some or all of the remaining amount owed on your loan if you work full-time for a specified period of time in certain occupations, or for certain types of employers.
- “Loan cancellation” usually applies to the various Perkins Loan Program cancellation benefits.
- “Loan forgiveness” usually applies to the Direct Loan and Federal Family Education Loan (FFEL) Teacher Loan Forgiveness Program or the Direct Loan Public Service Loan Forgiveness (PSLF) Program. You’re not required to pay income tax on loan amounts that are canceled or forgiven based on qualifying employment.
- “Loan discharge” generally refers to the cancellation your obligation to repay some or all the remaining amount owed on a loan due to circumstances such as school closure, a school’s false certification of your eligibility to receive a loan, a school’s failure to pay a required loan refund, or your death, total and permanent disability, or bankruptcy. In some cases, a loan discharge may also entitle you to receive a refund of payments previously made on a loan. Depending on the type of discharge, the amount of a loan that is discharged may be treated as taxable income.
The result of having all or part of your loan forgiven, canceled, or discharged may seem like a minor miracle. However, it also means that you will likely be required to report this amount on your tax return as income.
Also, bear in mind that tax consequences apply to all loans forgiven under Pay As You Earn Repayment Plan (PAYE), Revised Pay As You Earn (REPAYE), Income-based Repayment (IBR), and Income-Contingent Repayment Plan (ICR) after paying for 20-25 years.
What does all of this mean?
It means that in many cases you can expect a so-called “tax bomb” of between 10% and 37% of the student loan amount forgiven, depending upon your taxable income when the loan forgiveness occurs.
Let’s look at two examples:
In our first scenario, you’re a single individual, your taxable income after deductions is $60,000, and you’ve qualified for $100,000 loan forgiveness (amounts are approximate).
Before loan forgiveness, your federal income tax liability was $9,140. After the $100,000 loan forgiveness, your federal income tax is $32,890, resulting in a student loan forgiveness “tax bomb” of $23,750 (the difference between the two tax liabilities). Note that, based on the current tax brackets, the last $2,500 of loan forgiveness bumps you into a marginal rate of 32%. This is often referred to as “bracket creep” – movement to a higher tax bracket due to an increase in taxable income.
In our second scenario, you’re a married couple filing jointly, your taxable income after deductions is $80,000, and you’ve qualified for a loan forgiveness in the amount of $200,000 (amounts are approximate).
Before loan forgiveness, your federal income tax was $9,479. After loan forgiveness, your federal income tax is $55,779, resulting in a “tax bomb” of $46,300. So, your $200,000 loan forgiveness is taxed at nearly 23%. In this scenario, the highest marginal tax bracket is only 2% more than the previous one. So, your “bracket creep” is not so bad, but you still incur a large tax liability from the loan forgiveness.
Before calculating the potential tax due on a forgiven or canceled loan, you should note the possibility that part or all of the loan may not be taxable; the IRS defines these as “exceptions” and “exclusions”. IRS Publication 4681 addresses these “Exceptions” and “Exclusions”.
When you have a loan forgiven, the lender will issue you an IRS Form 1099-C, which reports the amount of the forgiveness. This form is then attached to your tax return and the amount is included in your taxable income. Receiving a 1099-C usually means that you owe taxes on the forgiven loan amount, but there are cases in which you may not.
Sometimes part or all of a debt that you don’t have to pay isn’t considered canceled debt, and may qualify as an “exception”.
Exception for health care providers
Generally, the cancellation of a student loan made by an educational institution because of services you performed for that institution or another organization that provided funds for the loan must be included in gross income on your tax return. However, there are two key exceptions:
- Repayment of student loans made to you by the National Health Service Corps Loan Repayment Program or a state education loan repayment program eligible for funds under the Public Health Service Act isn’t taxable if you agree to provide primary health services in health professional shortage areas.
- Amounts you received under any other state loan repayment or loan forgiveness program also aren’t taxable if the program is intended to increase the availability of health care services in underserved areas or areas with a shortage of health professionals.
After you’ve applied any exceptions to your forgiven or canceled loan, you might still be able to exclude it from your income. As with exceptions, if a canceled or forgiven debt is excluded from your income, it is non-taxable. In most cases, however, if you exclude this amount from income under one of these provisions, you also must reduce your “tax attributes” (certain credits, losses, and basis of assets). You should refer to IRS Publication 4681 for more information about “tax attributes”.
Exclusion: Public Service Loan Forgiveness
Federal forgiveness programs like Public Service Loan Forgiveness (PSLF) exclude the amount from taxable income, and you won’t have to claim it on your federal tax return. Under this program, if you are employed by a non-profit organization and you meet the qualification requirements, then the amount of the forgiven loan is not considered as taxable income.
To qualify for this treatment, the loan must have been made by:
- The federal government, a state or local government, or an instrumentality, agency, or subdivision of one of those governments;
- A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law; or
- An educational institution: under an agreement with an entity described in (1) or (2) that provided the funds to the institution to make the loan, or as part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) (non-profit) organization.
Exclusion: Loan Forgiveness in the Private Sector (not including PSLF)
As noted previously, you may be required to report a forgiven or canceled loan amount as taxable income. Depending upon your income and the amount forgiven, your forgiven debt could cause you to shift into a significantly higher marginal tax bracket.
Loan Forgiveness Due to Personal or Financial Hardship
Federal student loan borrowers who can’t work due to an illness or injury may have their loans forgiven or discharged due to total and permanent disability and could also avoid being taxed on the amount. Borrowers can qualify in one of three ways: with doctor certification, Social Security benefits, or certification from the Department of Veterans Affairs.
Tax Forgiveness Due to the Insolvency Exclusion
If you don’t qualify for one of the relief options mentioned above, then one of the only ways left to avoid the tax hit from a student loan debt cancellation is to apply for an insolvency exclusion. Technically, a taxpayer is insolvent when his/her total liabilities exceed his or her total assets. Currently, an insolvent taxpayer is not required to include forgiven debts in income.
Note that if you’re eligible for an insolvency exclusion, it may not be for the full amount of your cancelled loan debt. Also, these rules may change. You will need to complete IRS Form 982 to apply for this exclusion. You can estimate the value of the exclusion using the worksheet in IRS Publication 4681.
Preparing for the Tax Bomb
If you think part or all of your student loan debt may be forgiven, some financial planning strategies can help minimize the future tax bill. Because loan forgiveness has such significant tax consequences, you should discuss possible strategies with your tax advisor or CPA.
One simple move is to set up a savings account to start building a reserve for the future tax liability. With twenty years to save, a relatively small amount each month can grow to a sizeable balance by the end. And, if there is a change to the tax treatment of loan forgiveness, you’ll have accumulated an extra pot of money for your retirement or another goal.
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