Inconsistent Tax Treatment of Student Loan Debt Forgiveness Creates Confusion

August 24, 2022

Student loan debt forgiveness has been at the forefront of recent federal policy discussions, with President Biden announcing a plan to use executive action to cancel up to $10,000 in student loan debt for most borrowers and $20,000 for Pell Grant recipients. 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.

Some Context

The initial pause in student loan repayment was conceived as an emergency relief measure in the wake of the pandemic lockdowns in the spring of 2020. Since then, the U.S. economy has, in many ways, recovered. But it’s been overheating for more than a year, as the federal government sent out an unprecedented $6 trillion in pandemic relief in the form of stimulus checks, bonus unemployment benefits, and enhanced child credits, among other things.

As a result, inflation has exceeded the target 2 percent rate for about a year and half with expectations that it will continue to exceed that rate for years to come. The Federal Reserve is playing catch up with a series of big interest rate hikes not seen in decades, sending shock waves through the stock market, the housing market, and now starting to show up in the labor market in the form of higher unemployment claims.

Details and Analysis of the President’s Plan

The plan announced by the administration would make inflation worse by increasing the deficit by more than $350 billion, fully offsetting all of the deficit reduction resulting from the Inflation Reduction Act, which was just signed last week:

  • The plan would forgive $10,000 to $20,000 of debt, with the higher level reserved for those who received Pell Grants, for those earning less than $125,000 ($250,000 for married couples). Based on estimates from the Penn Wharton Budget Model, that would cost at least $330 billion and maybe closer to $500 billion.
  • The distribution of these benefits is skewed to the high-end, with about 70 percent of debt relief accruing to borrowers in the top 60 percent of the income distribution. Meanwhile, the cost of inflation skews to the low-end, as the price of food, energy, shelter, and other necessities goes up.
  • The plan would also extend the pause on repayments “one final time” through the end of the year, at a cost of roughly $5 and $10 billion per month, including interest pause costs and impacts on existing forgiveness programs such as income-driven repayment (IDR) plans and the Public Service Loan Forgiveness Program (PSLF).
  • In addition, the plan would expand these existing forgiveness programs and make the rules more generous.

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 as 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 actually 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 tax burden arising from treating forgiven student debt as income partially undermines debt relief.

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, which is being expanded under this executive action.

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.

As it stands, it appears that most borrowers will be exempt from federal tax on this round of debt forgiveness. However, as our colleague Jared Walczak has pointed out, the discharged debt is likely subject to state income tax in several states.

The Big Picture

The President’s debt forgiveness plan is certainly beneficial to some, but it would add to the national debt and worsen inflation. In addition, it sets a new precedent and expectation for further debt forgiveness, which would further increase the national debt and inflation. It may also push tuition prices higher, as more students treat loans essentially as grants.

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

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The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.

The Tax Cuts and Jobs Act in 2017 overhauled the federal tax code by reforming individual and business taxes. It was pro-growth reform, significantly lowering marginal tax rates and cost of capital. We estimated it reduced federal revenue by $1.47 trillion over 10 years before accounting for economic growth.

Taxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.