More to Student Loan Forgiveness Than Meets the Eye
Imagine this: You graduate college with student loan debt. You enroll in an income-based repayment (IBR) program and after 20 years your remaining loan balance is forgiven. What a great feeling, right? It certainly is, until tax season comes along and you get a bill. Under the current laws, any federal student loan balance that is discharged or forgiven is considered taxable income.
In some cases, especially for those with higher incomes, the extra “income” can push you into a higher tax bracket. That means higher income taxes. It might be safe to assume that anyone who relied on an income-based repayment program to make student loan payments would not be able to pay the extra income tax from the forgiveness. Furthermore, while the IRS allows payments, it doesn’t have an income-based repayment program. If you do not pay your taxes in full immediately, they will charge you interest.
Some policymakers are trying to change that. Two bills were introduced in the 114th Congress to amend the Internal Revenue Code to exclude IBR forgiveness from taxable income. According to Congress’s tracker website, neither made it past introduction.
But there may be another way.
John R. Brooks, a Georgetown University Law Center Professor, argues that “creating taxable income … undermines the policy behind loan forgiveness” and that all loan forgiveness should be exempt from income taxes. Brooks proposes several ways the Treasury can address this issue without changing the tax laws, which would require congressional action.
If student loans are classified as scholarships, they would be excluded under the tax code. Brooks argues that scholarships and debt forgiveness are determined in similar ways, but on different ends of the loan process. Therefore, it would not be difficult to apply the same exemption scholarships get to debt forgiveness.
Definition of “Insolvency”
Under current tax laws, if an individual is considered insolvent, canceled debt is excluded from income tax. If the definition of “insolvency” is expanded to omit retirement accounts and personal residences, which contribute to a person’s worth but don’t accurately represent (taxable) income, more people who could use it would be granted exemption from taxation on student loan debt forgiveness.
Currently, federal student loans are treated like any other loan: the government gives the borrower a sum of money and the borrower is expected to pay it back. Brooks argues that the IRS can look at it a different way: like an income sharing agreement (an agreement that outlines payment conditions based on a percentage of the borrower’s income for a period of time, rather than depending on the amount loaned).
Since any borrower can enroll in an Income-based repayment program, which requires no more than 10 percent of the borrower’s income in payments for 20 to 25 years, the end of the IBR period is essentially the end of the obligation. In terms of an income sharing agreement, the borrower was never expected to pay the full amount, so there would be no remaining balance to forgive and tax.
Calculating Canceled Debt
If taxes are calculated when the borrower enters the income-based repayment program instead of when they complete it, the movement into the program would qualify as debt modification. That would result in a complicated calculation to determine how much the borrower would owe in taxes. The Treasury Department has chosen not to do those calculations in the past because of the time and resources it would take. Instead, they let the borrower off the hook.
It feels very unfair for forgiven student loans to be taxes as income, especially considering that those who need IBR programs the most are usually low-income with little to no emergency funds. It’s reassuring that there are several ways to fix this problem. However, we hope one of them is implemented soon. Forgiveness from IBR programs will start in July 2019.
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