Douglas Olsen
The discharge of student loans can be a complicated process, and it is important to understand the tax implications. Generally, the IRS taxes all income sources, and when a creditor forgives or discharges a debt, the forgiven amount is typically considered taxable income. However, there are exceptions to this rule, such as federal student loan programs like Public Service Loan Forgiveness or Teacher Loan Forgiveness, where the forgiven balance is likely to be tax-exempt. Additionally, certain student loan discharges, such as those occurring due to school closure or fraud, may also be excluded from taxable income. It is always recommended to consult with a tax professional to understand the specific tax consequences of a student loan discharge.
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What You'll Learn
Loan forgiveness under federal programs
Loan forgiveness is available under federal programs for federal student loans. These programs are typically targeted at borrowers with lower incomes, large amounts of debt, or public service jobs.
Income-driven repayment (IDR) plans are one such program. These plans cap monthly payments at a percentage of the borrower's monthly income and family size. Payments can be as low as $0 per month. After 20 or 25 years of repayment, the remaining balance on the loans may be forgiven.
The Public Service Loan Forgiveness (PSLF) Program is another option. PSLF forgives qualifying federal student loans after 120 qualifying payments (10 years) while working for a qualifying public service employer. Qualifying employers include government, federal, U.S. military, state, local, or tribal, or certain non-profit organizations. Only federal Direct Loans can be forgiven through PSLF.
The Teacher Loan Forgiveness Program is a third option. Teachers who teach full time for five complete and consecutive academic years in certain elementary or secondary schools or educational service agencies that serve low-income families may be eligible for forgiveness of up to $17,500.
Other federal programs include the U.S. Department of Defense's student loan repayment programs for military service members and the Segal AmeriCorps Education Award for participants who complete a term of national service in an approved AmeriCorps program.
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Death or permanent disability
In the United States, student loan borrowers who have their loans discharged due to death or permanent disability may, in some cases, no longer be required to pay taxes on the forgiven amount.
The American Rescue Plan Act (ARPA) allows individuals to exclude from their income certain student loans that were cancelled or discharged after 2020 and before 2026. Specifically, exclusions apply if the loan was discharged due to the borrower's death or total permanent disability.
Prior to the passage of the ARPA, forgiven student loan amounts were generally considered taxable income. However, in recent years, there have been changes to the tax code that provide relief for borrowers in the event of death or disability. As of 2018, the tax on student loan discharges for death and disability was removed, providing peace of mind to borrowers dealing with difficult circumstances.
It is important to note that there may be certain requirements and conditions for tax exemption. For example, in some cases, borrowers may need to complete a three-year monitoring period and meet certain income requirements to maintain their loan discharge status. Additionally, the current tax code change is set to expire on December 31, 2025, after which borrowers may again be subject to taxation on discharged loans.
Furthermore, the tax implications of student loan discharges can vary by state. While some states do not tax forgiven loans, others may tax them as income. It is always advisable to seek competent tax advice to understand the specific rules and regulations that apply to your situation.
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Loan discharge due to fraud or school closure
If your school defrauded you or closed while you were enrolled, your federal student loans may be discharged, and you may not have to pay them back. The IRS and Department of the Treasury have issued Revenue Procedures that provide relief when federal loans are discharged by the Department of Education under the Closed School or Defense to Repayment discharge process.
In these cases, the discharged loan amounts are not considered gross income, and you do not need to report them as such on your federal income tax return. The IRS also advises creditors not to issue a 1099-C form in these situations. However, it's important to note that this relief is specifically for federal student loans and does not apply to private loans.
If your school closed, you may still be required to pay back your federal student loans if you:
- Withdrew from school more than 120 days before its closure (with some rare exceptions).
- Are enrolled in another educational program.
- Have completed all the coursework for your program, even if you haven't received your diploma or certificate yet.
- Completed a comparable program through a "teach-out," where you transferred academic credits to another school.
If your school defrauded you, you may qualify for state-level loan forgiveness programs that offer tax-free loan forgiveness. However, if you don't qualify for a federal program, your loan forgiveness may be taxable for state income tax. Consulting a tax professional can help clarify your specific situation.
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Income-driven repayment plans
Income-driven repayment (IDR) plans are monthly student loan payments that are set at an amount that's intended to be affordable based on your income and family size. IDR plans are available for most federal student loans, and you can use the Loan Simulator to estimate your monthly payments under different plans.
There are four types of IDR plans offered by the Federal Student Aid Office of the U.S. Department of Education:
- REPAYE Plan: Generally 10% of your discretionary income.
- PAYE Plan: Generally 10% of your discretionary income, but never more than the 10-year Standard Repayment Plan amount. To qualify, the payment you'd be required to make must be less than what you would pay under the Standard Repayment Plan with a 10-year repayment period, and you must be a new borrower.
- IBR Plan: Generally 10% of your discretionary income if you're a new borrower on or after July 1, 2014, but never more than the 10-year Standard Repayment Plan amount. Generally 15% of your discretionary income if you're not a new borrower on or after July 1, 2014, but never more than the 10-year Standard Repayment Plan amount. To qualify, the payment you'd be required to make must be less than what you would pay under the Standard Repayment Plan with a 10-year repayment period.
- ICR Plan: This is the only available income-driven repayment option for PLUS loan borrowers with dependents. Any borrower with eligible federal student loans can make payments under this plan.
It's important to note that defaulted loans are not eligible for any IDR plans. Additionally, Direct PLUS Loans for parents and Federal Family Education Loan (FFEL) Program PLUS Loans for parents are not eligible for any of the IDR plans. However, parent PLUS loan borrowers can consolidate their Direct PLUS Loans and FFEL PLUS Loans into a Direct Consolidation Loan to become eligible for the ICR Plan.
Under an IDR plan, you're required to recertify your income or family size annually. However, if you provide consent for secure access to your federal financial information, your IDR plan can be automatically recertified each year.
Any remaining balance on your IDR plan after the repayment period will be forgiven but may be considered taxable income.
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Tax-free loan discharge
Generally, the IRS considers all income sources taxable. When a creditor cancels, forgives, or discharges a debt, they erase some or all of the amount from your outstanding balance. The amount forgiven is typically included in your gross income and is subject to income taxes unless a tax law specifically excludes it from taxable income. Your student loan lender will report a forgiven balance on Form 1099-C, Cancellation of Debt.
However, there are certain scenarios where loan forgiveness is considered tax-exempt. These include:
- Qualifying federal loan programs: If you successfully participate in specific federal loan programs such as Public Service Loan Forgiveness or Teacher Loan Forgiveness, any loan forgiveness received is typically not taxable.
- Death or permanent disability: In the unfortunate event of death or permanent disability, neither you nor your estate will be taxed on any forgiven debt under federal student loan programs.
- Loan discharge due to fraud or school closure: If your loan is discharged due to fraud or because your school closed during your enrollment, the forgiven amount is usually not taxable.
- COVID-19 relief: During the COVID-19 pandemic, the CARES Act provided temporary relief by suspending student loan payments, interest accrual, and collection actions on defaulted loans. Additionally, employers were allowed to make tax-free student loan payments of up to $5,250 per employee annually from 2021 through 2025.
- Student loan repayment assistance programs: Certain student loan discharges and amounts received or forgiven under specific student loan repayment assistance programs may be excluded from taxable income.
It is important to consult with a tax professional to understand how debt forgiveness could affect your specific situation and to plan accordingly. Additionally, certain forms, such as Form 982, may need to be attached to your tax return to claim exclusions or reductions related to loan discharges.
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Frequently asked questions
It depends on the type of loan and the repayment plan. If you qualify for a federal student loan program offering tax-exempt loan forgiveness, you won't have to pay taxes on the discharged loan. However, if you don't qualify for such a program, the forgiven amount is typically considered taxable income.
Public Service Loan Forgiveness, Teacher Loan Forgiveness, and similar federal loan programs typically qualify for tax-exempt loan forgiveness. Additionally, if your loan is discharged due to school closure during enrollment, fraud, or if you pass away or become permanently disabled, it will likely be tax-exempt.
If you receive a Form 1099-C, Cancellation of Debt, from your student loan lender, it means that the forgiven balance is taxable and must be included in your gross income.
Loan forgiveness typically refers to when the remaining balance of your loan is forgiven after completing a payment plan, while loan discharge refers to when the loan is forgiven for other reasons, such as school closure or permanent disability.
You can consult a tax professional to understand how debt forgiveness will affect your taxes and plan accordingly. You may also want to save the money you would have paid towards your loans to cover the potential tax bill.
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