Federal Student Loans and Taxes – A Primer

Posted on Mon, May 24, 2021 ©2021 Drucker & Scaccetti

Bag of MoneyBy: Steve R. Rossman, CPA, MT

 

The recent spotlight on student loans has been intense. Every consideration from suspending payments to outright forgiveness is being discussed in the halls of Congress and the White House. This topic is widely impactful as a recent Forbes article sites current student loan debt in the Unites States tops a record $1.7 trillion amongst 45 million borrowers. So, what is the law today for how loans are handled in the wake of COVID-19, and what might the tax and financial landscape look like if loans are forgiven? Today, we offer a primer on this very question and its possible outcomes.

 

Student Loan Interest and Forbearance During COVID

 

As part of the CARES Act passed in March 2020, and extended by President Biden’s Executive Order in January of 2021, federal student loan payments (principal, interest, and collection action) have been suspended/frozen (also known as forbearance) through September 30, 2021. This will have no tax implications for students/borrowers because the loan is not cancelled, it is just delayed, and the borrower still must pay the loan.

 

If the taxpayer PAID student loan interest in 2020, it would be deductible (if the taxpayer’s income is below certain thresholds). Here is an excerpt from the IRS Website on Student Loan Interest:

 

Student loan interest is interest you paid during the year on a qualified student loan. It includes both required and voluntarily pre-paid interest payments. You may deduct the lesser of $2,500 or the amount of interest you actually paid during the year.

You claim this deduction as an adjustment to income, so you don't need to itemize your deductions.

 

Tax Implications of Loan Forgiveness

 

In a recent Florida bankruptcy court case (Mallett, (Bktcy Ct FL 2021) 127 AFTR 2d 2021-540), an education loan was non-dischargeable in bankruptcy. The court held that because the borrower took a student loan interest deduction on a signed tax return, the loan was an education loan and could not be discharged in bankruptcy.

 

In general, the only way that a student loan can be discharged in bankruptcy is when the borrower is experiencing “undue hardship.” The following factors are used to determine undue hardship:

 

  • If forced to repay the loan, the borrower would not be able to maintain a minimal standard of living.
  • There is evidence this hardship will continue for a significant portion of the loan repayment period.
  • The borrower made good-faith efforts to repay the loan before filing bankruptcy.

While knowing federal student loans are generally not dischargeable in bankruptcy may seem trivial, the Biden administration’s push to have federal student loan debt forgiven may have a much bigger impact.

 

Is Student Loan Forgiveness Taxable?

If the government takes the next step and cancels some/all federal student loans, then the loan forgiveness, in many cases, will be taxable under current law. This possible future legislation could also provide different tax treatment for student loan forgiveness; it is too early to say. However, generally, when a debt is forgiven, student loans or otherwise, the amount forgiven represents taxable income in the year it is written-off.  For student loan debt, there are exceptions to the taxability of the forgiveness, including if the forgiveness is contingent upon working in a certain profession or for a specific number of years (i.e., forgiveness for public service loans, teacher loans, law school loan repayment assistance. programs, and National Health Service Corps loan repayment programs are not taxable).

 

Here is an example how student loan forgiveness would be taxed based on current law:

 

If a borrower has $10,000 of student loans forgiven in 2021, she would have $10,000 of Cancellation of Debt (COD) Income and would presumably receive a 1099-C for 2021.  When the borrower files her 2021 tax return (in April of 2022), she will have $10,000 of income to report for the COD Income.  If the borrower is in the 20% federal tax bracket, this will result in additional tax of $2,000 ($10,000 x 20%), which will be due in April of 2022 when 2021 taxes are filed.  The good news is that the borrower does not have to pay back $10,000, but the bad news is that she owes $2,000 in taxes on the forgiveness. 

 

A Look into Our Crystal Ball If Federal Student Loans are Forgiven

 

As we have seen from loan forgiveness in the Paycheck Protection Program (PPP), the loans forgiven under the PPP are not taxable to business owners if the loans are used for eligible business expenses.  Perhaps this will set precedence for the taxability of forgiven student loans.  Another possibility is that a portion of federal student loans will be forgiven and may not be taxable, like we saw with the first $10,200 of unemployment compensation that was not taxable for 2020.

 

For now, we must wait and see how Congress proceeds. Once there is more clarity on this subject, we will provide an update blog, so stay tuned!

 

Navigating the tax rules for federal student loans can be challenging and rather daunting. If you have questions about student loans and your taxes, contact us using the comments section below.

Topics: Students, student loans, student loan debt, COVID-19, CARES Act, loan forgiveness, Paycheck Protection Program, ppp, debt forgiveness, borrowers

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