As you may be aware, total outstanding student loan debt in the U.S. has reportedly ballooned to over $1.4 trillion, and as more and more students face the serious problem of rising debt, many are counting on loan forgiveness programs. But student borrowers, as well as parents with Parent PLUS loans, need to be aware that a huge student loan forgiveness tax bill is the downside of student loan forgiveness.
Loan Forgiveness Basics
Your lender expects you to repay your loans even if you don’t complete your education, can’t find a job related to your program of study, or are unhappy with the education you paid for with your loan. This is true even if you were a minor (under the age of 18) when you signed your promissory note or received the loan.
However, certain circumstances might lead to your loans being forgiven, canceled, or discharged. The U.S. Department of Education explains how these terms are used:
- “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.
- “Loan discharge” generally refers to the cancellation of a borrower’s 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 a borrower’s eligibility to receive a loan, a school’s failure to pay a required loan refund, or the borrower’s death, total and permanent disability, or bankruptcy. In some cases, a discharge may also entitle a borrower 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 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.
In addition, you may be eligible for discharge of your federal student loans based on “borrower defense to repayment” if you took out the loans to attend a school that misled you, or engaged in other misconduct in violation of certain state laws, and if the school’s act or omission directly related to your federal student loans or to the educational services that you paid for with the loans.
As with loans made to students, a parent PLUS loan follows the same general guidelines: they can be discharged if you (the borrower) die, become totally and permanently disabled, or if your loan is discharged in bankruptcy. Your parent PLUS loan may also be discharged if the child for whom you borrowed dies.
The Downside: A Huge Student Loan Forgiveness Tax Bill
The result of having all or part of your loan forgiven, canceled, or discharged may seem like a godsend. 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. Hence, you could expect a student loan forgiveness “tax bomb” of between 10% and 37% of the amount forgiven, depending upon your taxable income after loan forgiveness.
Before we attempt to calculate the potential tax due on a forgiven or canceled loan, we should first address the possibility that all or a portion of the loan may not be taxable; the IRS defines these as “exceptions” and “exclusions”. IRS Publication 4681 (2017), Cancelled Debts, Foreclosures, Repossessions, and Abandonments addresses “Exceptions” and “Exclusions”. For purposes of this article, I am summarizing the most relevant parts.
Taxes and Student Loans: What are “Exceptions”?
When you have a loan forgiven, your 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 included in your taxable income. Receiving a 1099-C usually means that you owe taxes on the amount, but there are cases in which you may NOT owe taxes on the forgiven student loan amount.
Sometimes a debt, or part 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 some state loan repayment or loan forgiveness programs 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. Check with your program to be sure and assume these funds are taxable unless it’s obvious that they are not.
What Are “Exclusions”?
After you have applied any exceptions to your forgiven or canceled loan, there are several reasons why 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 nontaxable. 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). Again, refer to IRS Publication 4681 for a detailed discussion of tax attributes.
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 previously mentioned, you may be required to report the forgiven or canceled loan amounts as taxable income (going forward, I’m using the term “forgiveness”). To understand this better, you should look at the 2018 federal tax table. It shows the new tax brackets*, and includes two MAJOR bracket shifts: from 12% to 22%, then from 24% to 32%.
Depending upon your income and the amount forgiven, your “tax bomb” could also cause you to shift into a significantly higher marginal tax bracket, a phenomenon known as “bracket creep”.
*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:
Before loan forgiveness, his federal income tax was $9,140. After loan forgiveness of $100K, his federal income tax is $32,890, resulting in a student loan forgiveness “tax bomb” of $23,751. Note that the last $2,500 of loan forgiveness pushed him into a marginal rate of 32%.
Consider the scenario in which a married couple filing jointly reports taxable income after exemptions & deductions of $80,000, and has qualified for a loan forgiveness in the amount of $200,000 (again, all figures are approximate). The table shows the tax rates based upon their income in each bracket:
Before loan forgiveness, their federal income tax was $9,479. After loan forgiveness, their federal income tax is $55,779, resulting in a “tax bomb” of $46,300. Hence, their $200K loan forgiveness is taxed at nearly 23%. In this case, the highest marginal tax bracket is only 2% more than the previous one. So, their “bracket creep” is not so bad, but they still have a hefty tax bill as the result of forgiveness.
Loan Forgiveness Due to Personal or Financial Hardship
Federal student loan borrowers who cannot work due to an illness or injury may have their loans forgiven or discharged due to total and permanent disability and furthermore 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.
This last scenario recently made headlines in Michigan, when a wounded veteran had $223,000 of federal student loans forgiven, and then received a $62,000 tax bill in its place. So, he turned to his state and congressional representatives for assistance. A few months later, the Michigan Senate approved Senate Bill 642, to ensure that disabled veterans do not have to pay state income tax on student loan debt that was forgiven due to the veteran’s injuries.
Unfortunately, the IRS still treated debt cancellation as income, so he was being asked to pay federal income taxes on the entire amount, hence the federal tax bill remained $62,000. But Congress came to the rescue: loans that are forgiven on or after January 1, 2018, due to “total and permanent disability” are no longer reported as taxable income. The bad news is that the change, part of a massive overhaul of the tax code spelled out by the Tax Cuts and Jobs Act, is not retroactive.
Tax Forgiveness Due to the Insolvency Exclusion
If you don’t qualify for one of the relief options mentioned previously, then one of the only ways left to avoid the tax ramification of a student loan discharge is to apply for an insolvency exclusion. A taxpayer is insolvent when his or her total liabilities exceed his or her total assets. Currently, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent.
Keep in mind that if you are eligible for an insolvency exclusion, it may not be for the full amount of your loan discharge. Also, bear in mind that 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.
Are Retirement Accounts Protected from the IRS?
The IRS can seize retirement accounts, including 401(k) plans, IRAs, self-employed plans like SEP-IRAs, and Keogh plans. The key to defending retirement accounts from IRS seizure is to understand that the IRS “stands in your shoes”, which means that if you cannot get to the retirement money, the IRS cannot get to it either. Many retirement plans allow access to funds only at separation from service, retirement, or death/disability.
Thus, if you are still employed you likely have no ability to withdraw the retirement money, therefore the IRS has no ability to seize it. This may also apply to the company contributions to your 401(k) plans; however, the amount you personally deposited from your paycheck, as well as vested company contributions, may still be subject to seizure because you have access to these funds. Reference is found in Internal Revenue Manual 5.11.6.2, which governs IRS seizures of retirement accounts.
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 guideline, you should pay as little as possible to get maximum loans forgiven, and have as much left over as possible. The consultants at Student Loan Planner typically use debt to income of 1.5 or more if you are applying for forgiveness.
Hopefully, this article has enabled you to have a better understanding of the tax consequences of loan forgiveness and provided you with a few guidelines & strategies to help you along the way. As always, manage your money wisely and plan ahead for contingencies.
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has there been cases of couples filing separately and then later amend to filing together?
Yes but you only want to do it if you made a mistake and not as a typical strategy, or if you no longer have loans you can amend
Under Federal Perkins Loan Cancellation for Teachers, are cancelled amounts taxable to the recipient?
This might be an important nuance. Perkins loans are cancelled not forgiven via the route that would add them to income, so I’m pretty sure it’s non taxable
Will the canceled loans from the Career Education Corporation be taxed?
The Settlement: What Happened
Career Education, which operates the for-profit colleges Colorado Technical University and American InterContinental University and serves approximately 34,000 students, agreed to cancel $493.7 million in student debt for nearly 180,000 former students. The Illinois-based company faced allegations of fraud and deceptive practices, including allegedly misleading students about its job placement rate and actual cost of earning a degree, among other practices.
To be honest not sure about that. I would lean towards not being taxed but I’m double checking on it.
Thank you for looking into it!
I got a response from a student loan attorney Dionne. Here’s what he said:
I haven’t seen a student with a CEC loan that received a 1099. I believe the settlement required cancellation as opposed to discharge, so no 1099. If the borrower receives one, they should dispute it with CEC.
If that fails, call the IRS at 1-800-829-1040 and start a Form 1099 complaint. The IRS will send the borrower an IRS Form 4598, Form W-2, 1098 or 1099 Not Received, Incorrect, or Lost. The borrower would attach the Form 4598 to the tax return.
Wow. HUGE thanks for looking into this and doing it so quickly. SO grateful for your help!
How does one calculate the estimated percentage (Ex: 10-37%) of their loan forgiveness that would be taxed by the IRS?
The top tax rate you have when the loans are forgiven. It’s not predictable unless you know tax brackets in 2030s
Can the IRS seize Social Security Retirement Funds if you owe a substantial amount after student loan forgiveness?
Thank you.
That has never been tested before, but normal tax settlement rules would apply presumably if you have more assets than liabilities. If you only have social security then your tax is likely not due at all under the insolvency rule exemption.
a basic question, but, to be clear, outstanding principle and interest will be forgiven with PSLF, correct?
Has this been the intent of the program and have those who successfully filed gotten forgiveness for both principle and interest?
Correct
Not to mention that over 25 years these loans will accrue interest so your 40,000 loan could end up being a 150,000 loan by the time the period passes for forgiveness… Now you will be liable for an enormous amount of income taxes — it could even be higher – for those with 100,000 loans it could easily reach 500,000 or 600,000 — this problem needs to be addressed!
Student loan interest grows at a simple rate of interest because of government rules, so the most a 100,000 balance could become is around 300,000.
Thanks for your response. Can you please provide a citation to the tax code where PSLF is called out as tax exempt relief. I believe it is in the tax code but a cannot seem to find it now.
It isn’t cited here directly but this is a great place to search regs
https://www.law.cornell.edu/cfr/text/34/685.219
I was told prior to converting parent PLUS loans to a consolidated Direct loan, then qualifing for PSLF and tax forgiveness, that the only income based repayment option was ICR (for parent loans).
Now about a year after the changes, I’m told I can change from ICR and reduce payments by selecting PAYE, REPAYE, IBR plans but I’m fearful there is a downside.
What are your thoughts?
You have to do double consolidation, which is very difficult, so you’ll probably need to stick to ICR.
I am seeing mixed answer on the internet to my situation and really want to get the accurate answer. This year I found out about the ‘Closed School Discharge’ program and I was approved for that. My college closed my senior year for financial reasons and I never finished my degree. All of my federal loans were discharged and all payments I made for the last 15 years were returned to me.
The main question is, will I get a 1099 for that discharge and have to claim it as income?
There are answers of ‘yes’ and ‘not taxable’ all over the internet. I am just trying to find the answer that is correct.
I don’t believe you will. But if you did it would probably be a 1099-C. I would expect no tax from this.
Hello,
I have recently read that student loans discharged due to a total and permanent disability are no longer federally taxable if the three-year monitoring period fell within certain years. Do you know if the State of Indiana will tax the amount discharged? My three-year monitoring period ended in 2019. Thank you for your help!
That’s a tough one do you mean private loans or federal? Federal is now tax exempt as of 2017. Private I believe is still taxable when forgiven.
I was referring to federal loans. I have asked the Indiana Department of Revenue twice about this. One time they said that I would be taxed from the State, and the other time I inquired about this, they said I would not be taxed. I have even consulted a few CPAs, and they seemed to believe I would not be taxed by Indiana, but they did not seem confident. I am at my wit’s end. I appreciate your response.-Cindy
If you are taxed, you’ll receive a 1099-C. I’d ask a CPA to see if you could qualify for an insolvency exclusion, which would mean your assets are lower than your forgiven debt. In that case it’s likely it’d be forgiven tax free at all levels. I’d also suggest asking a student loan attorney like my friend [email protected]
Cyndy,
I have a similar situation, TPD with outstanding Federal Student Loans which are exempt from taxed by the IRS. However, I have not yet contacted the State of Indiana Treasury. My 3 year monitoring period has just started, so I have a little time to find out what will happen. I would greatly appreciate if you could keep me updated on what you find out and if you the State of Indiana charges you a tax on your discharged loans. Where did you go to contact the right people as I know it can be very confusing? Do you have a phone number?
Thanks for taking the time to read and consider helping me figure something out. Have a Merry Christmas,
Todd
Hey
As you mentioned, the safest way is to pay minimum now and set up an account to pay the massive tax later in life, and we never know what will be the taxes in the future, it could be higher or lower.
Can you mention again what kinda loans will not have “tax bomb” issue?
Direct loans that are paid via the PSLF program are tax free when forgiven. Otherwise you have to pay tax on anything forgiven.
What about loans that are repaid with an IBR and are also in the PSLF program. Will the dishcharged amount be taxable or not?
Not taxable
i have applied for my Student loans to be permanently disabiled i saw that i may get taxed by the state need advice thanks
i live in West Virginia
I participate in a Federal Nursing Loan Repayment Program as part of the Nurse Corp administered by the Health Resources and Services Administration. The website distinctly says that the funds are taxable. I receive a 1099-C. Above you indicate that these funds are exempt. Does this mean that Federal govt doesn’t tax it but states can choose to or not? How should I proceed, because right now I’m looking at a $6000 tax bill!!
We clarified it above you’re correct tried to make it more clear now
Thank you for your input. I learned a lot. Is my assumption correct, that you have to pay taxes on canceled loan and interest or loan only? We have 154k student loan at 6% interest. If we keep IBR payments our loan will skyrocket to 600K, do we pay taxes on the 600K or original loan of 154?
It’s the full amount, but bc interest doesn’t compound it accrues so that balance will likely double not quadruple. So the tax bill will be much lower.
So, I’m quite concerned for various reasons, but I have a specific question. At this moment, my husband owes almost $200,000 in student loans thanks to compounding interest, and is in the REPAYE program. We have given up trying to pay it off. That means our “forgiveness” will be an order of magnitude that I don’t wish to think about. Suffice it to say, my best guess is that in the future, the amount forgiven will put us in the 37% tax bracket if the bracket remains as it is today. We will need to, naturally, make payments to the IRS until we die because we’ll never pay off the tax burden before we croak because it will be so huge. My main question is whether or not the actual tax burden associated with the forgiven loans is subsequently forgiven if my husband dies, or if, when he dies, I’ll have to keep paying the taxes until I also die. I mean, if he dies before the tax bill comes due, the whole amount is forgiven. Seems like any taxable amounts related to those loans should also be forgiven, but I’m guessing the government hasn’t thought of the little old ladies poorer than dirt trying to pay their dead husband’s gigantic tax burdens in old age. I’m terrified they’re going to come after my 401k that’s in my name if we are married filing jointly. Maybe that year we file separately? Will that take care of the death issue? Ugh.
Most of our clients have this concern and when they hire us we explain it to them and then they’re not worried about it anymore (studentloanplanner.com/help)
Yes it’s forgiven in event of death but realistically you just need to save a few hundred a month in a brokerage account and will have enough to cover the tax payment. Also the interest on REPAYE in not compounded it grows at a simple rate of interest. Long explanation as to why.
How is interest considered income? Wouldn’t the forgiveness be based on the face value of the loan amount?
Interest is the cost you pay to borrow the money, so it becomes part of your final bill that’s due – which is why it’s included in the taxable forgiveness.
Hi,
I’m sure this has been asked before but I can’t seem to wrap my head around this. Lets say you’re in the 10% tax bracket (pre-student loan forgiveness) and you have $500k+ of student loans forgiven this year. Does that mean your tax bracket jumps up to 37%? Thanks.
The tax bomb is a concern of many borrowers. In our podcast episode number 79, Travis addresses this by saying “If the tax bomb ruins your finances, I’m going to be stunned. The IRS code has something called the insolvency rule. Basically, if your assets are less than your debt, you don’t owe the taxes on the debt. A good CPA can get the debt discharged.”
So, if after 20 years I owe $1,800,000 but only have $1,500,000 in assets, then will entire loan will be forgiven with no tax bomb of $900,000? Also, can the IRS change this code?
Thanks
That’s a great question for a tax professional. In theory, that’s how it works but it isn’t so cut and dry.
My private student loan by Chase in 2009 was forgiven and a 1099c filed December 31st 2017. The IRS states i now owe taxes on that amount. I am permanently and totally disabled. I married my spouse in 2015. We filed jointly in 2018. She is a federal employee as a n RN. They have attached the debt to her also. If the 1099c had been filed 24 hours later I would not owe taxes. We have 3 kids under 18.
In a nut shell, what can I do?
Reach out to these guys https://studentloantaxexperts.com/ and mention SLP as the referral source for a discount if you decide to hire them.
Amy,
Thank you for the studentloantaxexperts.com site. I will be in touch with them next month. Happy Holidays!
Todd
You’re welcome – happy new year!
For the insolvency exclusion – Is real estate debt considered a liability? If I make a low down payment to buy one or more investment/rental properties prior to the year of expected taxable forgiveness, I would have hundreds of thousands of dollars worth of new debt which be considered a liability. Could this be a strategy to qualify for at least full or at least partial insolvency?
You’d want to consult a tax professional to ask about specific scenarios. You definitely don’t want to be accused of tax fraud, so strategies like that should be vetted by a professional.
How would someone push off their standard forgiveness tax year?
I currently have been in repayment for 5.25 years. My initial loan was 195k…now it is at 270k. I am on a PAYE 20 year plan with forgiveness at end of term..
If in 5 years my loan has grown by 75k, what will it be in 15years? Im estimating that original 195k will be close to 500k at end of the 20 year tem in the year 2035 .
What should I do? My fogiveness will probably be close to 400k??
Any advice on how to go about this.
I currently desperately seeking a Public Servive Job in order to obtain “true” untaxed FORGIVENESS.
I suggest you book a consult with someone on our team to review your plan. It can give you peace of mind about your repayment plan so you’re not so anxious about the tax bomb.