SAN JOSE, california, October 19, 2021 / PRNewswire / – There has been a lot of talk lately about canceling student loans. A popular resolution, for example, calls on President Biden to use executive action to undo up to $ 50,000 of student debt for all US student borrowers.

It is still unclear how the Biden administration will react to pressure to introduce a new student loan cancellation policy. But whether borrowers receive a loan discharge through new legislation or through an existing program, here’s what to consider along with how the forgiveness could impact tax liability. tax, from myFICO.

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Reception $ 50,000 student loan cancellation may seem wonderful at first glance. But if those donated dollars are considered taxable income by the federal government, you might find that you suddenly owe an additional amount. $ 10,000 or more (depending on your tax bracket) to the IRS on your next tax return.

Whether or not the student loan rebate is tax exempt usually depends on the type of rebate you receive. But recent congressional legislation has temporarily expanded the availability of the tax-free student loan forgiveness. Here’s what you need to know.

What types of student loan forgiveness are still tax-exempt?

The IRS says that, as a general rule, if the debts are: “Canceled, canceled, or discharged for an amount less than the amount you owe, the canceled debt amount is taxable and you must report the canceled debt on your tax return for the year of cancellation.“

But there have always been exceptions to this rule, especially when it comes to forgiveness of student loans. For example, 26 United States Code § 108 states that when students attend programs that “encourages its students to serve in professions with unmet needs or in areas with unmet needs,” their student loans can be released tax free.

This means that most occupation-specific student loan exemption programs are tax exempt at the federal level. This would include the Public service loan forgiveness program program (PSLF), the Teacher loan rebate program, and Perkins loan cancellation.

The cancellation of an occupation-specific student loan is not the only type of forgiveness that is automatically excluded from income on federal tax returns. Other notable exceptions include closed school discharges, false certification discharges, and unpaid reimbursement discharges.

When can student loan forgiveness be considered taxable income?

The most notable type of federal student loan cancellation that could be taxable is the forgiveness received at the end of a income-based repayment plan (IDR). Currently there is four IDR plans:

• Pay as you earn (PAYE)
• Review of compensation as you earn (REPAYED)
• Income Based Refund (IBR)
• Income Based Reimbursement (ICR)

Depending on the IDR plan they join, borrowers will receive a discount on any remaining balance after 20 to 25 years. If a borrower’s income was relatively low during this 20 to 25 year repayment period, the amount remaining to be repaid could be substantial.

Under current tax rules, these canceled balances would be normally be considered taxable income. In addition to the IDR remission, federal student loan discharges due to death or disability have historically been considered taxable income by the IRS.

Related: Student loan basics: from getting a loan to paying it back

Are All Federal Student Loan Repayments Currently Tax Free?

Yes, the Biden administration American rescue plan, which went into March 2021, included an income tax exclusion for all federal student loan releases through December 31, 2025.

This new exclusion makes IDR cancellation 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 Reductions and Employment Act (which entered into force January 1, 2018) had already tax-exempt releases in the event of death and disability until 2025.

It is important to understand that new laws passed by Congress directly influence only federal the imposition of the student loan forgiveness. Depending on where you live, you may still have to state income taxes on the canceled debt.

While many states that charge state income tax follow the federal government’s definition of Adjusted Gross Income (AGI), some do not. Check with your state’s revenue department or consult a tax professional to learn more about the impact of student loan cancellation on your state’s tax bill.

How can insolvency reduce the taxation of student loan forgiveness?

There is one more exception that can reduce the tax consequences of canceling your student loan: insolvency. The “insolvency rule” has been part of the IRS tax code for decades and applies to all canceled debt, not just student loans.

When borrowers have total liabilities greater than the total fair market value (FMV) of all their assets, the IRS considers them insolvent. And this insolvency can reduce or, in some cases, completely eliminate the tax liability of their debt cancellation.

The IRS provides a insolvency worksheet for borrowers who have recently benefited from debt cancellation. To complete the worksheet, you will need to list all your debts (credit cards, auto loans, personal loans, student loans, etc.) and the FMV of your circulating assets (bank accounts, retirement accounts, tangible fixed assets, etc.).

Let’s say you have $ 25,000 in assets and $ 50,000 of total liabilities, making you insolvent by $ 25,000. Then we will say that you receive $ 20,000 in the event of a student loan cancellation. Since your insolvency before termination ($ 25,000) was greater than the canceled amount ($ 20,000), the total amount would be excluded from your taxable income.

But let’s modify the example above and assume that $ 40,000 of your debts are student loans and you receive a write-off for the full amount. In that case, $ 15,000 of the cancellation must be included in your taxable income since you cannot exclude more than the amount that you are insolvent. Here is the calculation:

$ 40,000 (debt canceled) – $ 25,000 (insolvency amount) = $ 15,000 taxable income

The bottom line

All student loan forgiveness and discharges are exempt from federal income taxes until 2025. But what if you only signed up for an IDR plan and won’t qualify for a discount before another 10, 15 or 20 years?

In these cases, there is certainly a chance that any rebate you receive at that time could be considered taxable income by the IRS. The good news is, you have plenty of time to plan. And the sooner you start saving for a future “tax bomb”, the easier it will be to do so without straining your income. budget.

Let’s say you plan to receive $ 50,000 forgiveness in 16 years and expect to owe about $ 5,000 tax on the amount remitted. If you started saving today, all you need to do is set aside about $ 26 per month.

Borrowers are also expected to continue to monitor future student loan legislation, particularly by the end of 2025. It is very possible that Congress could decide to make the student loan exemption permanently tax-free before the expiration of temporary arrangements.

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