Income-Based Student Loan Forgiveness May Be Taxable Income

Continuing our conversation on student loans (here, and here), the President made news Monday by signing an executive order capping student loan payments at 10% of a graduate's monthly income.

The order expands eligibility for a program called Pay As You Earn to about five million new borrowers beginning in December of 2015. The program has been in existence since 2012 and currently requires the borrower to be under at least a partial financial hardship. Currently, out of the 37 million student loan borrowers, less than two million are enrolled in the program (about 4%).

A key feature of the program is that under certain conditions the balance owed is actually forgiven after 20 years of payments (or 10 if working for the government or a non-profit).

Unfortunately, under current tax law, this income-based forgiveness would be considered taxable income. This issue was discussed by Eric Solomon, Assistant Secretary for Tax Policy, in a 2008 letter to the House of Representatives.

However, loan forgiveness under and [Income-Contingent Repayment] or [Income-Based Repayment] is not based on the Code § 108(f)(1) requirement that the borrower work in a certain profession in a certain period of time. Thus, the loan forgiveness under HEA §§ 455(e) and 493C(b)(7) does not satisfy the requirements for exclusion under Code § 108(f). 

Thus, unless the current tax law changes, any Pay As You Earn loans that are forgiven create a taxable event for the borrower in the year of forgiveness. Note that this does not apply to public service employees, such as teachers, who do qualify for non-taxable forgiveness.

This isn't necessarily a bad thing. If a borrower is in the 15% tax bracket, for example, $10,000 of student loan forgiveness would mean not having to pay back that $10,000 at a federal tax cost of $1,500 - meaning they are still ahead of the game by $8,500 in this scenario.

Of course framing it this way ignores that any income tax generated by loan forgiveness is due by the tax deadline. The IRS doesn't extend that deadline for payment for any reason, and interest begins to accrue on any unpaid taxes beginning April 15th. Remember that filing an extension extends the time to file, but never the time to pay. State taxes could also be applicable, depending on your residence.

I would hope that the Congress would address the tax issue at some point, but I am not in the impossible business of predicting what Congress will or won't do, even when it's in the best interest of the public.

Since every tax situation is different, I would recommend discussing this issue with your income tax advisor.

My conclusion on all of this is that this is less of a student loan problem and more of a college cost / education on basic economic principles problem. In my opinion, this program treats the symptom (borrowing to pay for college) instead of the disease (the high cost of college). College is expensive because the return on most college degrees is lucrative - when demand is high, the price goes up, just like any other commodity.