Is My Student Loan Forgiveness Taxable?
November 29, 2022
by Jerry Zeigler
Follow the latest student loan forgiveness developments here.
Student loans and student loan forgiveness have been in the news a lot this year after President Biden announced a historic student load forgiveness plan in August.
Student Loan Forgiveness Plan Background
On Aug. 24, 2022, President Biden announced a new student loan forgiveness program. This new loan forgiveness program aims to provide loan forgiveness for millions of federal student loan borrowers. Learn more about the plan and how it affects you here.
Student Loan Forgiveness Plan Challenges
There are lawsuits challenging the program. I don’t know if the challenges are going to stop this new student loan forgiveness program, but anyone who may have debt forgiven under this program should factor into their financial planning the possibility that the new plan might not be implemented.
Additional Student Loan Forgiveness Options
That said, even if the program is not implemented, there are other student loan forgiveness programs available. You can find information on various programs to have federal student loans forgiven, canceled, or discharged here and here. Also, be aware that there are income-driven repayment plans available which may allow you to make lower monthly payments and have any remaining student loan balances forgiven once the plan’s requirements are met. If the new student loan forgiveness plan is implemented, it will also modify income-driven repayment plans.
The Basics of Debt Forgiveness & Federal Taxes
When debt is forgiven, meaning the lender decides you don’t have to pay it back, the IRS views that as a financial benefit to the borrower, and as such, it’s treated as income.
The IRS calls it “canceled debt,” and it gets reported on a form 1099-C. It is required to be reported on the 1099-C when the debt forgiven is $600 or more (unless the forgiven debt is in an approved exception). Generally speaking, canceled debt is taxable income.
For most situations, there are two ways to avoid canceled debt being taxable.
1. One way is if you were insolvent at the time the debt was forgiven. Insolvent s means your total debts, all debts, not just what was forgiven) are more than the value of your assets. In that case, some or all of your canceled debt will not be taxed. The IRS provides an insolvency worksheet that helps you with your tax return filing in this situation in Pub 4681 (page 7). Let’s look at a simple example:
Let’s say you have $10,000 of debt canceled. Your total debt is $20,000, and your total assets (per the insolvency worksheet used in Pub 4681) are worth $10,000. This means your net worth is negative $10,000. You are insolvent by $10,000, and that means none of the $10,000 is taxable.
But let’s say instead you have only $15,000 of total debt, and $10,000 is forgiven. If your asset value still adds up to $10,000 then: $15,000 – $10,000 = $5,000 of negative net worth. You are insolvent by $5,000; therefore $5,000 of the canceled debt is taxable.
Many of us like to avoid math, and the second way can help us avoid math in some cases.
2. The second way for canceled debt to be exempt from taxation is if the canceled debt falls into one of the exceptions to being considered canceled debt income (most likely no 1099-C will be received) or if it qualifies as one of the exclusions for canceled debt income to be included in gross income. The impact of either being an exception or an exclusion is the same: the income is not taxable.
For any student loans forgiven under this new program, they are not taxable. In many cases, federal student loans forgiven or canceled are not taxable. Some other canceled debt situations are not taxable as well, and those situations can be found here.
But What About State Taxes?
All of the above talks about federal taxes. A few states will tax canceled debt even if it isn’t taxed by the federal government. That applies to student loan debt forgiveness as well.
The tax policy center provides some guidance on which states tax student loan forgiveness. I provided the link for information purposes, but don’t depend on just that third-party research. Check your state’s income tax provisions as well through official sources and documents.
Student loan forgiveness is a great opportunity to make your financial situation better. Fortunately, one thing you don’t have to worry about with the new student loan forgiveness program is federal taxes.