Student loans are notoriously difficult to escape, but there are some situations where student loan forgiveness can happen. Teachers, government employees, and members of other programs may be able to apply for student loan forgiveness.
But there’s a catch. When student loans are forgiven, borrowers may be surprised to see a big tax bill at the end of the year.
This topic is currently in flux, as there are proposals to make student loan forgiveness tax free. But for now, let’s look at the question: When is student loan forgiveness taxable?
What situations allow student loan forgiveness?
Unless you’re part of a qualified program (most commonly available for teachers and government employees), you typically cannot have your student loans forgiven or discharged. Even in bankruptcy, it is nearly impossible to have student loans canceled.
You could have your federal student loans forgiven if:
- Your school closes
- You become severely disabled or die
- You declare bankruptcy (in rare cases)
- Your eligibility was falsely certified
- You withdraw from school, but your school didn’t refund the proper amount to the lender
- You are a teacher or work in a public service career
- Your school committed fraud or misrepresented its services
As you can see, the options for student loan forgiveness are very limited. If you do qualify, however, it’s important to understand the tax implications of student loan forgiveness.
Is student loan forgiveness taxable?
For most taxes, you have to earn real income. Most commonly, this happens with your job. You are paid a certain amount of money, and you pay a percentage of that to the government. With student loan forgiveness, the amount forgiven can be treated (and taxed) as regular income.
Let’s say you are not married, earn $40,000 per year as a teacher, and have $50,000 in student loans. Earning $40,000 per year, your top tax rate is 25 percent. Because of how tax brackets work, you would not actually pay 25 percent of your total income. Your tax bill would be $5,771.25 with an effective tax rate of 14.4 percent.
But in that same year, you get your $50,000 remaining student loan balance forgiven. According to the current tax code, that $50,000 is treated as income, more than doubling your taxable income from $40,000 to $90,000. Thanks to saving $50,000, the IRS treats it like you actually earned $50,000 extra. So you have to pay taxes on that “income.”
Now, your taxes paid would be $18,271.25 with an effective tax rate of 20.3 percent. But you never got paid that $50,000, so it’s really like you have an effective tax rate of nearly 50 percent!
If this seems unfair to you, you’re not alone. Someone earning $40,000 per year may already be struggling financially. Add on an extra $10,000+ in student loan forgiveness tax, and that person is hardly scraping by.
There is one current exception to this rule: insolvency.
Insolvency and student loan forgiveness tax
When student loans are forgiven, you’re issued a form 1099C, which includes the amount of forgiven taxes to be included as income. But there is an exception for people who are considered to be “insolvent.”
Insolvency means your total liabilities are more than your total assets. If you are insolvent immediately before your loans are forgiven, you may have a loophole that allows you to lower your tax bill.
Let’s say Zack has $3,000 in the bank, a car worth $5,000, and $10,000 in retirement savings. He also has $15,000 in credit card debt, a $5,000 auto loan, and $20,000 in student loans.
His current net worth is his assets ($18,000) minus his liabilities ($40,000), giving him a net worth of -$22,000. If his $20,000 student loans are forgiven, he is still insolvent with a net worth of
In this case, because Zack is insolvent both before and after the loan forgiveness, he is off the hook and does not have to pay any income taxes on his student loan forgiveness.
Down the hall from Zack, his neighbor Wendy has $40,000 in assets and $60,000 in liabilities, of which $30,000 is student loans. Before her student loans are forgiven, Wendy is insolvent by $20,000, but after the loans are forgiven, she has a positive net worth of $10,000.
If her loans are forgiven, her solvency position is changed from -$20,000 to +$10,000. The “income” on the starting insolvent position is not taxable, but the remaining $10,000 is taxable.
Upstairs in the corner penthouse, lawyer Vanessa has $300,000 in assets and $150,000 in liabilities, of which $75,000 are student loans. Because she is solvent both before and after her $75,000 student loans are forgiven, the entire $75,000 is taxable.
Consult an expert if you face loan forgiveness
As you can see from the examples, this is complicated stuff. If you are in a position to have your student loans forgiven, you could end up with a massive tax bill or a very small one. The deciding factor is your net worth and how much is being forgiven.
To make sure you are on the up-and-up with the IRS, you are best served by working with a tax expert to make sure your tax bill is both correct and as low as possible. A trip to the accountant might sound expensive, but it could save you thousands in student loan forgiveness taxable income. That’s an investment well worth the cost.
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