Inconsistent Tax Treatment of Student Loan Debt Forgiveness Creates Confusion

Starting on September 1^st, federal student loan payments will resume after a three-and-a-half-year pause on payments and accrued interest following the onset of the COVID-19 pandemic. The resumption comes three months after the U.S. Supreme Court struck down President Biden’s student loan debt forgiveness plan in June.

As borrowers focus on adjusting their financial plans for the restarting payments, both the administration and Congress continue to explore alternative ways to forgive student loan debt. Under current law, the tax code handles debt forgiveness differently depending on the borrower’s repayment plan—canceling student loan debt would have new, potentially complicated tax implications for borrowers, as the forgiven debt can be treated as taxable income in some cases.

Recent Developments on Student Loans

The initial pause in student loan repayment was conceived as an emergency relief measure at the onset of the pandemic in the spring of 2020. Since then, the U.S. economy has recovered following an unprecedented $6 trillion in pandemic relief in the form of stimulus checks, bonus unemployment benefits, and enhanced child credits, among other things.

The pandemic relief has been phased out over the past two years as the economy recovered, inflation rose, and the public health crisis ended, but the student loan payment pause was continually extended until the president’s student loan forgiveness plan was struck down in June. That plan would have forgiven $10,000 to $20,000 of debt for people earning less than $125,000 ($250,000 for married couples), which would have increased the deficit by more than $330 billion.

While the president’s debt forgiveness plan was struck down in court, calls to forgive student loan debt will continue to be part of the broader policy and political debate. In addition to increasing the national debt and potentially worsening inflation, future forgiveness would set a new precedent and expectation for further debt forgiveness, which could lead students to take on more debt, leading in turn to more forgiveness and transference to the national debt, and more inflation.

While the forgiveness aspect of the administration’s plan was struck down in court, President Biden also expanded income-based repayment options and made the rules more generous, which are expected to take full effect by July 1, 2024.

Among other changes, these new rules increase the amount of discretionary income required before making payments in an income-based plan from 150 percent to 225 percent of the federal poverty level and reduce the minimum payment from 10 percent to 5 percent of discretionary income.

The changes would likely increase the share of borrowers who receive automatic forgiveness of their outstanding balance at the end of the loan term (typically 20 or 25 years under IDR plans), increasing the number of borrowers who run into a tax bill when these loans are forgiven.

The administration’s recent changes to income-based repayment may also push tuition prices higher, as more students treat loans essentially as grants. The new rules put a fixed upper bound on the amount that needs to be repaid for a larger share of borrowers, encouraging more student debt and tuition increases by universities.

Taxable Income?

Under current law, the tax code treats forgiven or canceled debt as taxable income, with some exceptions. If a borrower has debt forgiven, it is treated as if the borrower earned additional income in the previous tax year equal to the amount of forgiven debt. For example, if a borrower with an annual taxable income of $35,000 owes $20,000 in debt that is subsequently forgiven or canceled, the $20,000 in debt is added to their taxable income for a total of $55,000. Generally, a borrower is provided a 1099-C tax form when debt is canceled or forgiven, which reports the forgiven amount as taxable income to the IRS and the taxpayer.

The current treatment is generally consistent with the “Haig-Simons” definition of income: consumption plus change in net worth. Under an income tax, lenders deduct the cost of the forgiven loan from their taxable income while borrowers include it in their taxable income, creating symmetry in the tax system.

Federal student loans forgiven under income-driven repayment (IDR) plans are typically treated as taxable income. Forgiveness under the plans is common because the borrower makes monthly payments based on their income, which may be less than the amount of interest accrued each month. The borrower’s loan balance under the plan may grow over time until the debt is forgiven, which usually occurs after 20 or 25 years of on-time payments.

While student loan forgiveness is generally included in taxable income, the current tax code contains a complicated patchwork of exceptions. The American Rescue Plan Act (ARPA) of 2021 temporarily exempted student loan forgiveness under IDR plans from federal taxation through 2025 under the rationale that a tax burden arising from treating forgiven student debt as income partially undermines debt relief.

While ARPA exempts discharged student debt from taxation federally, discharged debt is likely subject to state income tax in several states. As of 2023, Indiana, North Carolina, and Mississippi will treat forgiven student loans as taxable income, while several other states are still determining whether they will do the same.

The ARPA exemption is not the only way borrowers may avoid paying tax on forgiven student loans under current law. For example, borrowers working at nonprofit organizations or in the public sector are exempt from tax if they are forgiven under the Public Service Loan Forgiveness (PSLF) program.

Another inconsistency involves the tax treatment of forgiven debt associated with closed schools. The rules were so obscure that even the Treasury Department was not initially aware of the associated income exclusion provisions. Since 2015, Treasury has sought to clarify the rules surrounding how discharged loans associated with closed colleges are treated in the tax code, arguing the compliance burden on borrowers and the administrative burden on the IRS to quantitatively assess a given borrower’s owed tax was “excessive in relation to the amount of taxable income that would result.” The Treasury subsequently issued rules to exclude any discharged loans for affected borrowers from being counted as taxable income.

Recent congressional legislation has moved toward exempting forgiven debt from tax in other circumstances. The Total and Permanent Disability (TPD) Discharge program, for example, which cancels federal student loan debt if the borrower cannot maintain gainful employment due to a medical condition, did not have an income tax exclusion prior to 2017. After the Tax Cuts and Jobs Act (TCJA) of 2017 was passed, however, forgiven student loan debt under the TPD became exempt from taxation. The exemption, like the temporary moratorium on the tax treatment of IDR loan forgiveness, is set to expire after 2025.

Lawmakers have also proposed excluding all canceled student debt from taxable income. The Student Tax Relief Act would permanently exclude all canceled student debt from tax without changing the tax treatment for lenders. The Act would include student debt carried by up to nine million borrowers enrolled in IDR plans who owe $530 billion—more than half of federal student loans in repayment in 2020. Alternatively, the IRS could classify forgiven student loans as qualified scholarships, as they did prior to 1973, making student debt cancellation non-taxable like other types of scholarships.

Moving forward, policymakers must weigh the benefit of expanding tax exemptions for forgiven student loan debt against the complexities and inequities created in the tax base if lenders get write-offs and a select group of borrowers get exclusions. From the standpoint of tax simplicity and neutrality, the rules regarding the tax treatment of forgiven loans should be consistent and broadly applied, rather than fragmented and preferential.