The Double Debt Loophole is a strategy to squeeze every last bit of efficiency out of a couple’s income-driven repayment plan towards forgiveness. If you’re going the forgiveness route, you want to minimize your payment as much as possible to maximize how much you get forgiven.
Let’s talk about what you can do to maximize the Double Debt Loophole now and after the COVID relief is lifted 9/30/2021.
Who should consider this strategy
Filing taxes separately to exclude spousal income from their payment is a common strategy for couples where only one spouse has the student debt. It’s also necessary to carry out the Double Debt Loophole when both spouses have student debt.
You should consider this strategy when loan forgiveness is inevitable (PSLF or private sector) and either:
A. Both spouses earn similar annual incomes and there’s a big discrepancy between student loan balances owed.
Kelly and John’s situation from my previous article shows a great example of this playing out.
If you and your spouse don’t make about the same income but you live in a community property state (Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington and Wisconsin), income is divided between both spouses equally on their federal tax return/1040 if filing taxes separately using the 8958 form.
This essentially makes you and your spouse’s AGI appear to be the same, thus making you a good candidate for the Double Debt Loophole via the Community Property State Loophole… a loophole within a loophole!
B. Both spouses owe about the same in student loan debt and there is a big discrepancy in spousal income (one spouse earns a lot more than the other).
Let’s take another example and say Rae and Blake both owe about the same in student loans: Rae owing $420,000, Blake owing $400,000.
Their income is quite different though: Rae earns $120,000 per year and Blake earns $250,000 per year. Rae’s going for taxable forgiveness on PAYE after 20 years and Blake’s planning for Public Service Loan Forgiveness (PSLF). Both are eligible for REPAYE and PAYE.
If they filed taxes jointly or both went on REPAYE (this plan always considers joint income when calculating your payment), joint income would be considered but their individual payment responsibility will be based on their proportionate debt load.
What does this mean? Let’s do the math for their payment assuming they’re both on on REPAYE or filing taxes joint PAYE:
The total household payment for an AGI of $370,000 would be $2866 per month.
- Rae’s Payment Proportion: $2,866 x 51% = $1,468 per month
- Blake’s Payment Proportion: $2,866 x 49% = $1,398 per month
Rae makes 48% less income than Blake, yet her payment is slightly more than Blake’s because of how the federal system proportializes the payment between spouses filing taxes jointly and/or on the repayment plan REPAYE.
This is tough for Rae because she’s personally no longer benefiting from the IDR plan like she would if her payment was truly just based on just her own income. In other words: She’s not achieving the goal of reducing her payment as much as possible to maximize her forgiveness.
Filing taxes separately allows you to base your payment off of your own income on the IDR plans PAYE and IBR. REPAYE always considers your spouse’s income regardless of tax filing status. These facts are important to remember.
Let’s run the numbers for Rae and Blake if they filed taxes separately (MFS) and apply for PAYE to compare to the above scenario:
Rae’s payment drops quite a bit, saving her $686 per month! But Blake’s payment goes up because his income is higher, and he’s no longer participating in the lower payment proportion if he were to go on PAYE since PAYE uses his own income to calculate the payment when filing taxes separately.
Insert Double Debt Loophole here: Let’s assume Blake goes on REPAYE and Rae goes on PAYE. Why? Think back: Blake benefits from having his payment being proportionalized because his balance is slightly lower than Rae’s.
Rae doesn’t benefit from REPAYE but would benefit from PAYE allowing her to calculate her payments based on her own income, if they file taxes separately:
So if Blake applied for REPAYE, and Rae applied for PAYE and they filed taxes separately, their total payment would be $2,180 per month, versus $2,648 if both were on PAYE filing taxes separately or $2,866 if both were on REPAYE/filing taxes joint.
How to implement this strategy
Step 1: Consider filing taxes separately next time
May 17, 2021 was tax day for 2020’s tax filings. Since that day has passed, 2021’s taxes may be the next opportunity to consider filing taxes separately with your spouse (unless you filed an extension).
We’re still in the midst of the CARES Act student loan payment relief which froze federal student loan payments until after January 31, 2022.
When the payment freeze is lifted, your IDR payment will resume at what it was prior to your payments being suspended unless you intentionally recalculated your payment since March 2020.
If you’re new to repayment and applying for an income-driven repayment plan now, the application links back to your most recently filed IRS tax return, pulling through your AGI (Adjusted Gross Income) to calculate your payment.
This means that if your most recent tax return on file isn’t already filed separately, you might not be able to implement this Double Debt Loophole strategy, immediately. But you could re-calculate your payments after 2021’s taxes were filed separately as early as February or March 2022.
Keep in mind there can be downsides to filing taxes separately that you should evaluate as well. Make sure that this strategy’s cost savings aren’t eroded by the potential consequences of filing separately.
These are the things you could be giving up when you file taxes separately because they’re for married couples filing jointly:
- Education credits or student loan interest deduction of $2,500
- Potentially more advantageous tax brackets
- Child care tax credit
- Earned income tax credit
- Exclusion or credit for adoption expenses
- Ability to contribute to a Roth IRA (however you can overcome this by doing a Backdoor Roth IRA conversion)
- Ability to deduct rental property losses
- Ability to take the standard deduction if one spouse itemizes
Step 2: Apply for the respective income-driven repayment plan
Submit your application for an income-driven repayment plan. Make sure that the correct tax return pulls through on the application. If not, close out of it and wait a few weeks before applying. Sometimes a tax return can take a few weeks to reflect for the IRS data retrieval tool within the income-driven application.
Who goes on REPAYE?
The spouse with the lowest student loan balance to reap the benefit of the proportionate payment allocation.
Who goes on PAYE or IBR?
The spouse with the lower income or the higher balance.
Make sure to sign off on each other’s applications. The Department of Ed makes spouses “co-sign” an income-driven application to:
- Confirm you’re married (you get a larger poverty-line deduction for being married)
- Confirm you both filed taxes the same way, and
- To “link” you two together for the payment calculation.
Signing off on each other’s applications does NOT obligate you to your spouse’s loans in any way. I know, I know… I wish they’d change the terminology from cosign to something else!
Step 3: Make your payments
I know that this loophole can make one’s head spin. Not sure if this strategy could work for you and your spouse? Do you have the added complexity of living in a community property state? Schedule a consultation with me for your customized student loan plan.