Student Loan Forgiveness Tax Bill: A Major Downside of Loan Forgiveness.
Student Loan Forgiveness Tax: As you may know, total outstanding student debt in the U.S. has reportedly ballooned to over $1.4 trillion, and as more and more students face the serious issue of rising debt, many rely on loan forgiveness programs.
But student borrowers, as well as parents with Parent PLUS loans, need to be aware of the downside of student loan forgiveness tax bill.
Loan Forgiveness Basics
Your lender expects you to repay your loans even if you do not complete your education, are unable to find a job related to your study program, or are unhappy with your loan education. This is valid even if, when you signed the promissory note or got the loan, you were a minor (under 18 years of age).
However, some circumstances may lead to forgiveness, cancelation, or discharge of your loans. The U.S. Education Department discusses how to use these terms:
- “Loan cancellation” and “loan forgiveness” generally refer to the cancellation of a borrower’s obligation to repay some or all of the remaining amount owed on a loan if the borrower works 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. Borrowers are not required to pay income tax on loan amounts that are canceled or forgiven based on qualifying employment.
- “Lender discharge” generally refers to the cancellation of a borrower’s obligation to repay some or all of the remaining amount owing to a lender due to circumstances such as school closing, a school’s false verification of a borrower’s eligibility to obtain a loan, a school’s failure to pay the necessary loan refund, or the borrower’s death, complete and permanent disability, or bankruptcy. A discharge may also, in some situations, allow a debtor to receive a refund for previously made payments on a mortgage. The value of a loan to be discharged can be viewed as taxable income, depending on the type of discharge.
Types of Loan Forgiveness, Cancellation, and Discharge
The following table illustrates the various types of loan forgiveness, cancellation, and discharge, and how they apply to the various types of loans:
*FFEL program loans and PERKINS loans may become eligible for public service loan forgiveness if they are consolidated into the direct loan program.
Additionally, you may be entitled to discharge your federal student loans on the grounds of “borrower protection to repay” if you took out the loans to attend a school that deceived you or engaged in other wrongdoing in violation of certain state laws, and if the behavior or omission of the school is directly related to your federal student loans or the educational services you paid for with the loans.
As with student loans, a parent PLUS loan meets the same general guidelines: if you (the borrower) die, become completely and permanently disabled, or the loan is discharged in default, they can be discharged. You can also discharge your parent’s PLUS loan if the kid you lent for dies.
The Downside: A Huge Student Loan Forgiveness Tax Bill
The consequence of forgiving, canceling, or discharging all or part of your loan may seem like a godsend. It also means, though, that you are likely to be forced to record that amount as income on your tax return. Do note that tax implications apply for all loans forgiven under the Pay As You Earn Repayment Plan (PAYE), Revised Pay As You Earn (REPAYE), Income-based Repayment (IBR), and Income-Contingent Repayment Plan (ICR) after 20-25 years of payment. Therefore, depending on the taxable income after loan forgiveness, you might receive a student loan redemption “tax bomb” of between 10% and 37% of the amount forgiven.
Until we try to calculate the potential tax owed on a loan forgiven or canceled, we should first discuss the possibility that all or part of the loan may not be taxable; these are described by the IRS as “exceptions” and “exclusions.” IRS Report 4681 (2017), Loan Cancelations, Exclusions, Repossessions and Abandonments addresses “Exceptions” and “Exclusions.” The most relevant parts will be summarized for the purpose of this report.
Taxes and Student Loans: What are “Exceptions”?
Your lender will issue you an IRS Form 1099-C, which will report the amount of forgiveness, if you have a loan forgiven. This form will then be included in your tax return and will be included in your taxable income. Generally getting a Form 1099-C, means you owe taxes on the amount, but there are situations where you are NOT required to owe taxes on the value of the forgiven student loan.
Sometimes a debt you don’t have to pay, or part of a debt, is not considered a cancelled debt, and can 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.
What Are “Exclusions”?
There are several reasons why you may still be able to exclude it from your earnings after you have made any exceptions to your forgiven or canceled loan. As with exceptions, if your income lacks a debt that has been canceled or forgiven, it is non-taxable. Nevertheless, in most situations, if you exclude this amount from taxes under one of these rules, you also need to minimize your “tax attributes” (some loans, expenses, and asset base). For a detailed discussion of tax characteristics, please refer to IRS Publication 4681.
Public Service Loan Forgiveness
Federal forgiveness programs like Public Service Loan Forgiveness (PSLF) excludes 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.
Loan Forgiveness in the Private Sector (not including PSLF)
As mentioned above, you may be required to report the sums forgiven or canceled as taxable income. To better understand this, look at the Federal Tax Table for 2018. This shows the new tax brackets* and contains two MAJOR bracket shifts: from 12% to 22%, from 24% to 32%.
Your “tax bomb” could also cause you to shift into a significantly higher marginal tax bracket, a phenomenon known as “bracket creep,” depending on your income and the amount forgiven.
*Note that this only shows federal tax brackets; different states will have varying tax brackets, so be sure to factor your state income tax into the calculations.
Consider the following scenario: an individual reports taxable income after exemptions & deductions of $60,000, and has qualified for a loan forgiveness in the amount of $100,000 (all figures are approximate). The table shows the tax rates based upon his or her income in each bracket:
His federal income tax was $9,140 before the loan forgiveness. His federal income tax is $32,890 after loan forgiveness of $100 K, resulting in a $23,751 student loan forgiveness “tax bomb.” Remember that the last $2,500 in loan forgiveness brought him to a 32 percent marginal rate.
Consider the situation where a married couple filing together declared taxable income after $80,000 exemptions & deductions and eligible for a $200,000 loan forgiveness (again, both figures are rough). The table shows the tax rates in each class based on their income:
Their federal income tax was $9,479 before loan forgiveness. A federal income tax is $55,779 after loan forgiveness, resulting in a $46,300 “price blast.” Their $200 K debt waiver is therefore taxed at almost 23%. In this case, just 2 percent more than the previous one is the largest marginal tax bracket. So, their “bracket creep” isn’t that bad, but as a result of forgiveness they still have a heavy tax bill.
Loan Forgiveness Due to Personal or Financial Hardship
Federal student loan borrowers who are unable to work as a result of illness or injury may have their loans forgiven or discharged as a result of full and permanent disability and may also prevent taxing the amount. In one of three forms, lenders may qualify: with physician credentials, Social Security benefits, or Department of Veterans Affairs certification.
Recently, this last example made headlines in Michigan, when a disabled soldier forgave $223,000 in federal student loans, and then got a $62,000 tax bill instead. He turned for help to his state and congressional leaders. A few months later, the Michigan Senate passed Senate Bill 642 to ensure that veterans with disabilities do not have to pay state income tax on student loan debt forgiven due to the injuries of the veteran.
Sadly, debt cancelation was still treated as income by the IRS, so he was asked to pay federal income tax on the whole amount, so the federal tax bill stayed $62,000. Yet Congress came to the rescue: debts repaid on or after January 1, 2018 are no longer recorded as taxable income due to “complete and permanent disability.” The bad news is that the move is not retroactive, as part of a massive reform of the tax code outlined in the Tax Cuts and Jobs Act.
Tax Forgiveness Due to the Insolvency Exclusion
If you are not eligible for one of the above-mentioned relief options, then one of the only ways left to avoid a student loan discharge tax ramification is to apply for an exclusion from insolvency. If his or her total liabilities surpass his or her total assets, a taxpayer becomes insolvent. To the degree that the taxpayer is insolvent, a taxpayer is not currently required to include forgiven debts in earnings.
Keep in mind that it may not be for the full amount of your loan repayment if you are eligible for an exemption from insolvency. Keep in mind that these laws may also change. To order to apply for this exemption, you will need to complete IRS Form 982. You should estimate the exclusion price using the worksheet in IRS Publication 4681.
Are Retirement Accounts Protected from the IRS?
Including401(k) plans, IRAs, self-employed plans like SEP-IRAs, and Keogh plans, the IRS will seize retirement accounts. The trick to protecting IRS seizure retirement accounts is to recognize that the IRS “stands in your shoes,” which means the IRS can’t get to it either if you can’t get to the retirement money. Most retirement plans provide for separate access to funds from service, retirement, or death/disability.
So if you’re still operating, you still don’t have the ability to withdraw the retirement money, so the IRS doesn’t have the ability to take it. This may also refer for employer contributions to your401(k) plans; but, because you have access to these accounts, the amount you directly contributed from your paycheck may still be subject to forfeiture as well as vested company contributions. Reference can be found in Internal Revenue Manual 184.108.40.206, which controls retirement accounts IRS seizures.
Default & Foreclosure Is Not a Good Idea
Never default on your taxes: doing so will trigger tax liens, and it will have a huge negative impact on your credit score as well as your ability to borrow money in the future. As far as a foreclosure on a home, it is generally (but not always) the case that the IRS will not foreclose on a home to collect taxes. Most tax courts will make provision for “reasonable living accommodations”, which means that you must be allowed to have a residence for you and your family to live in. Again, be sure to consult with an attorney or tax advisor if you find yourself in this situation.
General Guidelines on Loan Forgiveness
As a general rule, in order to get full loans forgiven, you can pay as little as possible and have as much leftover as possible.
You should also set up a bank account to make monthly deposits for future payments or unforeseen events to provide a buffer. Eventually, you may be able to delay the year of repayment to one in which your tax bracket will be smaller, further mitigating the potential tax redemption bombs for student loans.
Ideally, this article has given you a better understanding of the tax consequences of loan forgiveness and provided you with some guidance and tactics to support you along the way. Manage your money carefully, as always, and prepare for contingencies.