Taxes Behind Cancelling Student Debt
I don’t have any special insight into whether the federal government will actually head down the road to cancelling student debt. It’s a popular phrase in certain corners of the media (probably especially popular among journalists with student debt they’re hoping to have cancelled). But what Washington will (or even should) do is outside my realm of expertise.
What I do know is that I’ve had several people approach me (virtually…thanks, COVID) with concerned over these calls for cancelling student debt. Tax concerns.
And they have a right to be worried.
With multiple people asking me about this, and student debt being an issue that can affect everyone, I figured it was worth diving into.
While I may not have the special insight into what Washington is going to do, I can give some insight into what cancelling student debt could do to your 1040.
For all those cheering for President Biden to take the loan monkey off their back, consider that you could be trading it for an IRS monkey.
And the IRS monkey carries guns.
Defining Income
In my Intro to Income Tax class, I try to hammer home the concept of income. Most people “know” what income is, but they don’t really know.
The IRS defines it as “all income from whatever source derived,” but that only partially covers it, too.
Even I’ve been lacking in my explanations, something that I should probably remedy in it’s own post. So let’s sum it up here: if you get something that makes you materially better off, it’s income.
Here’s some example.
- Trading time for cash = income
- Trading time for land = income
- Selling something for more than you bought it for = income
- Trading something for something worth more = income
- Finding a bucket of money = income
And so on.
Not everything is income. We’re not on Bjork levels here with music (linked to the SNL skit rather than the depressing Dancer in the Dark). But income is usually well beyond the typical salary that most people consider.
(Gifts are a weird exception that we’ll address that later on)
Cancelling Student Debt = Income
Now, to the most important part…cancelling student debt gives you income.
Here’s the boring legal explainer. If someone gives you money in exchange for a promise to pay them back, you are no better or worse off. Yes, you now have money, but that promise to pay it back is of equal value in the eyes of the law.
But what if the lender decided you don’t have to pay the loan back? Now you got money for nothing.
That is income.
And whether that loan was for a inadvisable sports car or for your education, cancelling the loan will still be income.
That means the IRS is going to come calling, expecting their piece.
Keep reading below for ALL the potential exceptions.
Looking At An Example With Numbers
Lucy is a musician who got her degree funded with a student loan. She has $50,000 in student loans outstanding (the max number of debt forgiveness I’ve seen floating around), which she has 20 years to pay off.
In her current gig, she makes $30,000 a year in taxable income.
If she’s single, her Federal income taxes due for 2021 would be $3,402.50
If that $50,000 of debt is waved away by an Executive Order, her taxable income would jump up to $80,000. Her Federal income taxes due would be $13,390. Or approximately $10,000 more in Federal income taxes.
Lucy is currently at a relatively low tax bracket. If she was already making more, that cancelled debt would be taxed even more.
Layer on state income taxes, which vary wildly but average about 5% across the US, and she’s likely paying $15,000 in extra income taxes in the year the loan is forgiven.
Oh, and cancelation of debt income messes with the Alternative Minimum Tax calculation, but there’s no way I’m discussing that here. It’s way too complicated (and, fortunately, no longer affects many people).
Better Off, But With Drawbacks
Make no mistake, Lucy is definitely better off. Having to pay $15,000 is quite a bit better than paying $50,000 with interest.
The difference is that the $50,000 will be paid over 20 years (or more, depending on the loan length). The $15,000 has to be paid right now.
So how could Lucy handle this? Looking at the current Tax Code, there’s a few ways. Some could potentially even be tax free.
Tax Payment Plans
So you’re suddenly saddled with $15k of taxes due to canceled student debt that you had no idea you were going to have to pay. Now what?
Rather than just being thrown into a debtors prison like in the olden days, the IRS will work with you to create a payment plan. They’re actually pretty reasonable about the whole thing, too.
Congratulations! You’ve traded a student loan for a lesser IRS loan!
You’d have to talk to a banker to see if this could cause you other issues, but typically a payment plan with the IRS is cheaper than any other sources of borrowed money.
Most states have similar payment plans, though I’ve heard some are harder to work with than the IRS.
Excluded Debt Income – Congress Edition
I’m sure there are a few people thinking, “Can’t I just not include the canceled debt as income? I mean, it’s the government doing it!”
The answer is that it’s up to Congress. If Congress signs a bill cancelling student debt, they can absolutely include a provision making the cancelled debt tax free.
In fact, they did something like that during the Obama administration, allowing those with student debt to work in certain approved areas for a certain amount of time to have their debt cancelled completely tax free.
That provision is still on the books, by the way. If you want to get a job with the government, it’s still a tax free way out of much of your student debt.
Here’s the thing: Congress would have to make this happen. If President Biden signs an Executive Order–a popular idea that’s been floating around–he simply doesn’t have the authority to make it tax free.
Excluded Debt Income – Gift Edition
Another way cancelling student debt could be tax free is if it’s considered a gift. Gift tax has it’s own weird rules, but it’s why when your grandma gives you a $20 check you don’t have to pay taxes on it.
If you have a private student loan with a bank, and they, out of the goodness of their hearts, decide to cancel your loan, that would be a tax free gift.
It would also be extremely unlikely, but that’s another issue.
Can the President gift loan forgiveness? I’m no political lawyer here, but it seems like we’d run into all kinds of Constitutional trouble if the President could gift other people’s money.
So I think we’re a no go on this potential tax free option.
Excluded Debt Income – Insolvency Edition
Finally, let’s discuss the option that is most likely to get people out of Cancellation of Debt income and make cancelling student debt tax free: insolvency.
IRC Section 108 allows any cancelled debt to be excluded from income if you simply don’t have the means to pay it.
This seems like a simple solution. But it may not be, depending on your particular situation.
Let’s go back to Lucy. Let’s say she owns nothing, she rents her apartment, she has no retirement accounts, and only has $100 in the bank. She clearly does not have the means to cover $50,000 of student loans.
She would be insolvent, and the IRS would not tax her on that cancelled student debt.
But what if she has a house with lots of equity? What if she has a partially funded retirement account? What if she has some highly appreciated comic books?
This is where things get tricky. The IRS wants to include basically everything to determine if she’s insolvent. The Tax Court has been more generous, allowing certain things to be excluded.
The IRS has made it clear that they do not agree with the Tax Court, meaning that if you have $50,000 in an IRA and you claim you can’t pay that $50,000 in cancelled debt, you may have to pay $100,000 to a lawyer to defend your case (friggin’ lawyers).
So it’s complicated.
But if you can prove you are insolvent (best done if you have a valuation professional document it for you), you can get out of that taxable income on that cancelled student debt.
Let’s finish off with an example for someone who is somewhat solvent:
Partial Insolvency Example
Thanks to an Executive Order, Lucy no longer has to pay back $50,000 of student debt. She knows that this will cause taxable income, but she’s not sure how much.
For various complicated reasons, her only real asset is $10,000 in the bank. She takes a screenshot of her bank account on the day of the Executive Order and saves it into her tax folder.
How much of that $50,000 forgiven debt is taxable income?
Only $10,000.
Since she is insolvent beyond that amount, the remaining $40,000 would NOT be taxable income.
Image by www_slon_pics from Pixabay
