Would Mass Student Loan Forgiveness Make Borrowers a Tax Nightmare?
As President-elect Biden continues to work on his transition, advocates for student loan borrowers are urging him to adopt a large student loan forgiveness as one of his first acts – even if it means bypassing Congress.
“Student loan debt keeps an entire generation from buying homes, starting small businesses and saving for retirement – all of which we rely on to grow our economy,” the Massachusetts senator said. Elizabeth warren, a strong supporter of the blanket student loan exemption. “Executive action to cancel student debt would be a huge economic stimulus during and after this crisis.” Warren requested up to $ 50,000 for student loan cancellations for each borrower.
“We agree,” the predatory student loan project said in a statement. Tweeter in response to Warren, calling on Biden to “write off billions” in federal student loan debt “on day one” through executive order.
“The Biden-Harris ticket campaigned for meaningful student debt relief,” the student debt crisis said in a statement last week. “We look forward to partnering with the Biden administration to implement not only the reforms included in their platform, but also to push for even more sweeping reform – including debt cancellation. for all borrowers. “
Biden has so far decreased to say whether he would pursue a large student loan forgiveness through executive action.
But critics of the massive student loan cancellation have questioned the legality of sweeping debt cancellation without the involvement of Congress. And they point to a potentially serious downside – the possible imposition of student loan cancellation. Could borrowers face a tax nightmare if their student loans are forgiven?
Debt cancellation is often taxable, but not always
The problem is that debt forgiveness – including partial forgiveness – can revert to the borrower as taxable “income”. In other words, the debtor or borrower may have to pay income taxes on the balance of the canceled debt, as if they were “earning” it in income. Borrowers in these situations still often get away with that in that they would pay significantly less overall by getting their debt canceled than they would otherwise through paying it off in full, even with the tax bill. But because the canceled debt can be a taxable event, borrowers could owe substantial taxes, which would be due all at once. And if the borrower does not pay immediately before the tax deadline, there can be significant penalties.
As an example, let’s say a borrower has $ 75,000 in unpaid debt. And $ 50,000 of that debt is forgiven or forgiven. If that $ 50,000 is taxed as “income,” the actual tax cost to the borrower will depend on a variety of factors, including which tax bracket the borrower is in and whether or not there is a tax. on state income. But assuming an overall effective tax rate of 30%, the borrower in this example might have to pay $ 15,000 in taxes. This is much cheaper than paying off the $ 50,000 balance in full, especially if it would have been paid in installments over time with interest. But getting to $ 15,000 all at once might be difficult for some borrowers and impossible for many.
The IRS has exemptions that allow borrowers in certain situations to avoid any tax liability on the canceled debt. For example, there is an exclusion for borrowers who obtain a forgiveness of their student loan through the Public Service Loan forgiveness and other professional student loan forgiveness programs, and for borrowers who obtain a discount. student loan due to a disability. Borrowers can also file for insolvency if their total debts exceed their total assets at the time of debt cancellation (this often requires borrowers to complete additional documents with their tax return).
However, the general exemption for student loans does not necessarily fall clearly within these exceptions. Congress could pass legislation that specifically exempts massive student debt forgiveness from tax, but if Biden acts unilaterally to write off student debt by executive order, he’s unlikely to win support from Congress. Critics of the massive cancellation of student debt are therefore worried about the possible tax implications.
Supporters of student loan forgiveness oppose taxation
Advocates for student loan borrowers suggest that critics’ concerns are overblown and that blanket student loan cancellation doesn’t have to be a tax nightmare for borrowers.
Proponents argue that the US Department of Education and the IRS have some discretion over the tax treatment of canceled debts. Consumer advocates point to the Borrower Against Repayment Defense program, which offers a student loan discount to borrowers who can prove they have been defrauded by their schools. The cancellation of the student loan under this program is not considered a taxable event, despite the fact that it does not clearly fall under one of the tax code exemptions. The IRS made a discretionary decision assume that most borrowers whose student loans are canceled through this program would likely be insolvent and therefore fall under the insolvency exemption, or that they would otherwise have had a legal defense against repayment based on fraud or misrepresentation. Supporters of the blanket student loan forgiveness argue that federal agencies could make a similar blanket decision, particularly if student loan forgiveness is restricted or means-tested based on the income or financial standing of the student. borrower.
Some advocates also argue that the massive cancellation of student loans in response to the COVID-19 pandemic could qualify as a “disaster relief payment” under the IRS code. A “disaster relief payment” is “any amount paid to or for the benefit of a person to reimburse or pay for reasonable and necessary personal, family, living or funeral expenses incurred as a result of a qualified disaster” . Such payments would not be taxable.
In addition, the government might characterize the general student loan exemption as a “general welfare” program, which the IRS defines as “Payments made under social benefit programs for the promotion of general welfare”. Such payments “are excluded from gross income under a concept known as the general welfare doctrine” and are therefore generally not taxable. It might be an exaggeration to claim that this doctrine applies if Congress does not expressly establish student loan cancellation as a general welfare program, but the Biden administration might point to the broad power granted by Higher Education Act to modify or impair federal student loans.
The easiest way to avoid a student loan cancellation tax nightmare for borrowers would be for Congress to pass legislation that specifically exempts general student debt forgiveness from tax. If that doesn’t happen and Biden goes ahead with an executive order to cancel student debt (which is far from guaranteed at this point), his administration would likely have viable legal arguments to exempt him from tax.
However, these legal theories have never really been challenged or tested in the courts in the context of the massive student loan cancellation. If Biden ends up issuing an executive order to cancel student loans and that executive action is challenged through litigation, it may ultimately be up to the courts to decide whether student loan borrowers will be hit hard. ‘huge tax bills.