Tue, 21 Sep 2021

Taxes on Forgiven Student Loans

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24 Aug 2021, 01:24 GMT+10

Taxes on forgiven student loans have been the norm for quite a while now since the IRS treats forgiven debt as income. However, you won't need to worry about the massive tax bill after 2025 because of the COVID-19 relief package enacted by Congress.

Regardless, it's still important to know everything about taxes on forgiven student debts, especially if your state income taxes are still affected. Or, if you want to go in for relief, that won't occur until 2026 or later.

This guide will show you what you need to know.

Federal Income Taxes On Forgiven Student Loans Stops From 2025

Previous efforts like the Underwater Student Borrowers Act have been to shield borrowers from improper taxes on forgiven student debt. But little was done. However, it all changed when Congress passed the student loan stimulus relief in March 2021.

The American Rescue Plan Act made federal, institutional, and private student loan forgiveness tax-free by 2025. The Democratic senators estimate that borrowers with $50,000 in income would save around $2,200 in taxes for every $10,000 that's forgiven.

Before, student loans exempt from taxes were those forgiven through Teacher Loan Forgiveness, Public Service Loan Forgiveness, and the National Health Service Corps Loan Repayment Program.

Loans discharged if a borrower dies or becomes permanently disabled were also excluded. Some borrowers, however, attempted to go for insolvency. That way, they won't have to pay taxes on their forgiven debts (more on that later).

It's critical to understand that tax laws will revert on January 1, 2026. That way, you can avoid any surprises later.

Taxes On Forgiven Student Loans: What To Expect

Most student loan borrowers take income-driven repayment plans such as PAYE, REPAYE, etc., as financial saviors when combined with loan forgiveness. These repayment plans cap your monthly loan payments at 10% to 20% of your income.

However, you need to consider some crucial factors. First, the IRS would consider loans forgiven under these programs as taxable income. That means you could have huge tax bills on your hands when your loans get forgiven.

For example, let's say you make payments under the IBR plan for 20 years, and you have $40,000 left in student debt.

That $40,000 could be considered taxable income. And that could cause your lender to send you a Form 1099-C which states the amount of the forgiven debt. It'll then be necessary to include in your tax forms such as Form 1040.

So even though you don't have to pay $40,000 in student loans, you would still have a massive tax bill to clear off. That amount can increase your federal tax bill by thousands of dollars, or even tens of thousands. And that doesn't include the potential state income taxes.

Federal Taxes And Student Loan Forgiveness Through Insolvency

When your loan debts are forgiven, you get a Form 1099-C from your lender. The form shows the amount of forgiven student debt to be added as income. But you can be exempted from this through insolvency loan forgiveness.

Insolvency is a technical tax term that means that what you owe (liabilities) is more than what you have (assets). So if you're insolvent right after your student debts are forgiven, you could have a way to reduce your tax bill.

Let's go through some key examples.

1. Instances where you don't have to pay taxes on your forgiven debts

Let's say Ernest has $10,000 in retirement savings, $3,000 in the bank, and has a car worth $5,000. So his assets amount to $18,000. He also has $5,000 in auto loans, $20,000 in student loans, and $15,000 in credit card debt. So his liabilities total $40,000.

Ernest's current net worth is $18,000 minus $40,000, which gives him a negative net worth of -$22,000. If he gets his student loans ($20,000) forgiven, he now has a negative net worth of -$2,000.

In this instance, Ernest is insolvent both before and after he gets loan forgiveness. Therefore, he won't have to pay any federal income tax on his loan forgiveness balance.

2. Instances where you pay total taxes on your forgiven student loans

Let's say John has $300,000 in assets, with $150,000 being a liability. And $75,000 are student loans. Now John will be solvent before and after her $75,000 loans are forgiven. That means the entire $75,000 loan balance is taxable.

Final Thoughts

First of all, don't worry about the taxes. We understand how the thought of paying taxes on a forgiven loan amount can be stressful. The best thing to do is choose a student loan repayment plan or loan forgiveness that works for you.

A lot of things can happen between now and when you get your loans forgiven. There can even be a change in the law, just like how Biden made all programs tax-free by 2025.

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