Plan to cancel up to $50,000 in student loan debt could come with tax bomb

Categories: Student Loans

By Kathryn Pomroy, Fox Business

As a rule, borrowers must pay taxes if a lender forgives, cancels or discharges a debt for less than the amount owed. That money is considered ordinary income for tax purposes. Yet, early in December, Senate Majority Leader Chuck Schumer urged President Joe Biden to cancel up to $50,000 for federal student loan borrowers — tax-free.

“[Biden] can also make it such that when they do this, they have no tax liability,” Schumer claimed.

While it’s true there are times when debt can be forgiven and still be tax-exempt, the circumstances are limited. Because this kind of action is rarely as simple as canceling debt, you could potentially be hit with a tax bomb at the end of the year if or when your student loans are forgiven.

Do I have to pay taxes on my student loan forgiveness?

Some tax policy experts say Biden’s incoming administration could use an executive order to cancel debt under the 1965 Higher Education Act to protect borrowers from a stiff tax bill upon forgiveness. But Goldman Sachs analysts noted that Schumer’s plan could come with “potentially significant tax implications that could do more harm than good” to borrowers.

In most cases, debt forgiveness is treated as taxable income, which could force student loan borrowers to pay up to 20% of the forgiven debt in taxes unless Biden makes a legislative or administrative change to U.S. tax rules. In other words, if Schumer’s plan forgives $50,000 in student loans, you would be taxed as if you were handed $50,000 in cash. And since this is technically income you never earned, coming up with the money for the tax bill might be tough. If that seems unfair, you’re not alone.

David Reischer, Esq., Attorney & CEO of LegalAdvice.com, agrees. “Generally, you must claim any student loan forgiveness you receive on your tax return. The amount you receive is counted against your taxable yearly income and added to your tax bill, [according to the IRS’s latest tax rules].“

Reischer adds, “But Schumer has specifically insisted that any new legislation that addresses this taxable event must eliminate taxes that would ordinarily be due from the cancellation of such a loan.” Schumer’s loan forgiveness plan would apply to all degree levels.

If you have private student loans and don’t qualify for student loan forgiveness, then you should consider refinancing your student loans. With today’s low rates, you could save time and money with a student loan refinance. Head to Credible now to refinance your student loans today.

Are there situations that allow for tax-free debt forgiveness? 

Student loan forgiveness doesn’t apply to private student loans. If you have federal Direct Loans, there are specific requirements you must meet to be eligible for loan forgiveness.

  1. Public Service Loan Forgiveness: PSLF forgives up to 100% of your Federal Direct Loans after making 120 qualifying monthly payments counted as eligible PSLF payments under a qualifying repayment plan. You must also be working full-time for a qualifying employer and work for 10 years before receiving PSLF loan forgiveness.
  2. Permanent disability or death: In 2018, the Trump administration made permanent disability and death discharges of federal student loans tax-free through 2025.
  3. Insolvency: If your total debts exceed your total assets, some or all of your loan forgiveness may not be taxable. 

If you’ve been impacted by COVID-19 and you’re trying to find ways to save, use an online tool like ​Credible to view a rates table that compares student loan refinance rates from multiple lenders at once without impacting your credit.

What to do in the meantime

One of the consequences of high unemployment and COVID-19 is the inability of many borrowers to pay off student loan debt. When in office, if Biden accepts Schumer’s proposal of $50,000 in loan forgiveness, it could give some breathing room to many students. But it’s also possible you’ll be on the hook for the tax on the amount forgiven.

If that happens, your lender will likely issue a Form 1099-C, Cancellation of Debt, for the forgiven amount. Because the IRS also gets a copy, it will expect to see this amount on your tax return. In the meantime, you might want to pursue other options, like refinancing your student loans. Use an online tool like ​Credible to get prequalified student loan refinancing rates without affecting your credit score.​

Refinancing your private loans when benchmark interest rates are so low can save you money over time and shorten the term of your loan. However, if you have federal loans, switching to a private loan might make you ineligible for government relief from a number of tax-free forgiveness programs, like PSLF.

If you have good credit and stable employment, your chances of getting a better rate are much better than if you have poor credit or you’re out of work. If you’re not sure what rate you’ll qualify for, use an online tool like ​Credible to compare student loan refinancing rates from multiple lenders at once without affecting your credit score.

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