Janice Lozano
Student loan forgiveness can be a huge relief for borrowers, but it's important to be aware of the potential tax implications. In some cases, the forgiven loan amount may be considered taxable income, resulting in a significant tax bill for the borrower. This situation is often referred to as a student loan forgiveness tax bomb. The tax consequences depend on various factors, including the borrower's repayment plan, loan program, and state of residence. While federal student loan forgiveness has been tax-exempt until the end of 2025, borrowers on income-driven repayment plans may face taxation on forgiven loan amounts starting in 2026. Additionally, some states have chosen to tax student loan forgiveness, adding further complexity to the issue. Understanding the tax liabilities associated with student loan forgiveness is crucial for borrowers to make informed financial decisions.
| Characteristics | Values |
|---|---|
| Taxable income | The forgiven amount is typically included in gross income and is subject to income taxes unless a tax law specifically excludes it from taxable income. |
| Tax-free circumstances | Public Service Loan Forgiveness, Teacher Loan Forgiveness, National Health Service Corps Loan Repayment Program, and similar repayment programs are not taxable. |
| Tax-free circumstances | Loan discharges due to closed schools, false certification, unpaid refunds, and death or disability are taxable. |
| Tax-free circumstances | Forgiveness of refinanced student loans may be eligible for tax-free treatment under certain circumstances. |
| Insolvency | If you were insolvent when the loan was forgiven, you may not have to pay taxes on the forgiven debt. |
| State-specific taxation | As of 2023, Indiana, North Carolina, Mississippi, and Wisconsin have stated that the balance of forgiven student loans will be taxed as income. |
| State-specific taxation | Taxpayers in Arkansas and California may face the same fate as the states are currently reviewing their tax laws and have yet to make a determination (as of February 2024). |
| Federal student loan forgiveness | Any amount of federal loans forgiven through income-driven repayment or other means is not considered taxable income through the end of 2025. |
| Federal student loan forgiveness | After 2025, borrowers on income-driven repayment plans may experience a student loan forgiveness tax bomb, with the remaining balance being taxed as income. |
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What You'll Learn
Student loan forgiveness tax bomb
Student loan forgiveness can be a lifesaver for some, but it may come with tax liabilities. A "student loan tax bomb" occurs when your student loan lender forgives all or a portion of your debt, causing you to include this amount in your taxable income. The size of a student loan tax bomb depends on the amount forgiven as well as your finances overall. In some instances, the forgiven student loan could push you into a higher tax bracket, further increasing your tax burden.
Some loan forgiveness programs are taxable and some are not. Under current law, the amount forgiven generally represents taxable income for income tax purposes in the year it is written off. However, there are a few exceptions. Student loan forgiveness is typically excluded from income if the forgiveness is contingent upon the student working for a specific number of years in certain professions. Public service loan forgiveness, teacher loan forgiveness, law school loan repayment assistance programs, and the National Health Service Corps Loan Repayment Program are not taxable. Loan discharges for closed schools, false certification, unpaid refunds, and death and disability are considered taxable income.
If you receive forgiveness after 2025, you may face a large tax bill that’s due in full immediately. The best way to prepare for this is to estimate your projected student loan forgiveness and set aside money before the tax bomb hits. After 2025, borrowers on income-driven repayment plans may experience a student loan forgiveness tax bomb. IDR plans last up to 25 years, and if you don’t pay off your loan during that term, the remaining balance is forgiven — but taxed as income.
Some states also tax student loan forgiveness. As of 2023, Indiana, North Carolina, Mississippi, and Wisconsin have stated that the balance of forgiven student loans will be taxed as income. Taxpayers in Arkansas and California could face the same fate — the states are currently reviewing their tax laws and have yet to make a determination.
If you can prove you were insolvent when the loan was forgiven, you can avoid paying taxes on the forgiven debt. This means that your total assets were less than your debt (including student loans, credit cards, and personal loans).
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State-specific student loan forgiveness tax laws
The taxation of student loan forgiveness varies across different states. While the federal government does not collect taxes on student loan forgiveness, several states levy taxes on it.
Some states that do not levy taxes on student loan forgiveness include Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. These states either have no income tax or limited tax.
On the other hand, states like Indiana, Mississippi, North Carolina, and Wisconsin tax student loan forgiveness. For instance, Wisconsin includes forgiven student loans under its taxable income, while Mississippi taxes cancelled debt as income.
Some states have ambiguous laws regarding student loan forgiveness. For instance, Arkansas's tax code does not explicitly mention the treatment of student loan forgiveness, and California has provided conflicting information on the matter.
The taxation of student loan forgiveness is a complex issue that varies from state to state, and it is essential to stay updated on the latest state-specific laws and regulations.
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Student loan forgiveness and insolvency
The taxability of student loan forgiveness depends on the type of loan forgiveness program. Some programs are taxable, while others are not. For example, Public Service Loan Forgiveness (PSLF), Teacher Loan Forgiveness, and the National Health Service Corps Loan Repayment Program are generally not taxable. On the other hand, loan discharges due to closed schools, false certification, unpaid refunds, or death and disability are considered taxable income.
The American Rescue Plan Act of 2021 made student loan forgiveness tax-free at the federal level from December 31, 2020, to January 1, 2026. This includes forgiveness through income-driven repayment plans, the Public Service Loan Forgiveness program, and other qualifying programs. However, if your loans are forgiven after January 1, 2026, the forgiven amount may be considered taxable income.
Now, let's discuss insolvency and how it relates to student loan forgiveness. Insolvency occurs when an individual's liabilities exceed their assets. In simpler terms, if you owe more money than you own, you are considered insolvent by the IRS. When a debt is forgiven or canceled, the IRS typically treats the forgiven amount as taxable income, known as Cancellation of Debt (COD) income. However, if you were insolvent at the time of forgiveness, you may not have to pay taxes on the forgiven debt up to the amount you are insolvent. This is known as the IRS insolvency exclusion.
To claim the insolvency exclusion, you need to fill out IRS Form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness." On the form, you will need to provide your personal information, check the box for "Discharge of indebtedness to the extent insolvent (not in a Title 11 case)," and enter the amount of forgiven debt you want to exclude from income. It is important to note that Part II of the form can be complex, and you may need to consult a tax professional for assistance.
Determining insolvency involves calculating your total liabilities and assets. Liabilities include any debt owed, such as credit card debt, car loans, mortgage debt, and student loan debt. Assets include cash, property, investments, and any other valuable possessions. If your total liabilities exceed your total assets, you are considered insolvent, and you may be able to avoid paying taxes on your student loan forgiveness.
It is important to note that the tax implications of student loan forgiveness can be complex, and it is always recommended to seek advice from a tax professional to understand your specific situation. Additionally, the information provided here may not be up-to-date, and it is essential to stay informed about any changes in legislation that may impact the taxability of student loan forgiveness.
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Federal student loan forgiveness and tax exemption
The American Rescue Plan Act of 2021 made federal student loan forgiveness tax-free through the end of 2025. However, this broader provision was not made permanent or extended by Trump's "big beautiful bill", which included a major overhaul of student loan repayment plans and rules.
While federal student loan forgiveness is currently tax-free, this is only temporary, and borrowers may face a federal tax bill again starting in 2026. Additionally, borrowers could be liable for state taxes following student loan forgiveness. Many states mirror the federal government's tax policy on student loans, and some states have already stated that the balance of forgiven student loans will be taxed as income. These states include Indiana, North Carolina, Mississippi, and Wisconsin.
There are certain circumstances in which student loan forgiveness is excluded from income and is not taxable. According to the Internal Revenue Code of 1986, gross income does not include any amount that would be includable due to the discharge of a student loan if such discharge was pursuant to a provision that requires the individual to work for a certain period in certain professions for specific employers. Some examples of loan forgiveness programs that are not taxable include public service loan forgiveness, teacher loan forgiveness, and the National Health Service Corps Loan Repayment Program.
On the other hand, loan discharges due to closed schools, false certification, unpaid refunds, and death or disability are considered taxable income. Additionally, the forgiveness of the remaining balance under income-contingent repayment and income-based repayment plans after 20 or 25 years of repayment is also considered taxable income.
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Student loan forgiveness for federal loan programs
There are several federal student loan forgiveness programs that may help you repay your loans. These include:
- Public Service Loan Forgiveness (PSLF): This program offers tax-free forgiveness of the remaining balance on your Direct Loans if you work full time for a government or not-for-profit organization.
- Teacher Loan Forgiveness (TLF): You may be eligible for forgiveness of up to $17,500 if you 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.
- Closed School Discharge: If your school closes while you're enrolled or soon after you withdraw, you may be eligible for a discharge of your federal student loan if you meet certain requirements.
- Income-Driven Repayment (IDR) Plans: Under an IDR plan, your monthly payment is based on your income and family size. After making payments for 20 or 25 years, the remaining balance on your student loans may be forgiven.
- Total and Permanent Disability (TPD) Discharge: If you have a disability that severely limits your ability to work, you may qualify for a TPD discharge, which means you don't have to repay your federal student loans.
- Military Service Benefits: The U.S. Department of Education and Department of Defense offer special benefits for military service members with federal student loans.
It's important to note that the tax treatment of student loan forgiveness varies depending on the program and your state. While some programs like PSLF, TLF, and IDR plans may offer tax-free forgiveness, others may result in a taxable event. As of 2023, states like Indiana, North Carolina, Mississippi, and Wisconsin have stated that forgiven student loans will be taxed as income. Therefore, it's essential to understand the specific rules and requirements of each loan forgiveness program and consult a tax professional for personalized advice.
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Frequently asked questions
It depends on your repayment plan and loan program. Any remaining balance after the payment plan ends is forgiven and likely considered taxable income in the year it occurs. However, if you receive forgiveness under a different federal student loan program, it will likely be tax-exempt.
Public Service Loan Forgiveness, Teacher Loan Forgiveness, law school loan repayment assistance programs, and the National Health Service Corps Loan Repayment Program are not taxable.
Loan discharges for closed schools, false certification, unpaid refunds, and death and disability are considered taxable income.
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