TaxWatch: Did you benefit from student-loan debt relief? Know the tax consequences
According to one recent estimate, the total amount of outstanding student loan debt is about $1.75 trillion. Of that, federal student loans total about $1.59 trillion. According to the same source, about 43.2 million student borrowers owe an average of slightly over $39,000 each. That’s a lot of debt!
The good news is that, in some cases, student loan balances can be forgiven or even paid off by an employer. This column focuses on the resulting federal income tax consequences for student loan borrowers who are lucky enough to have that happen. The lucky borrower might not be you, but it could be a loved one. Anyway, here goes.
Cancellation of debt (COD) income tax basics
The general federal income tax rule states that a taxpayer’s gross income includes cancellation of debt (COD) income, unless a statutory exception applies. The availability of these exceptions, which are found in Section 108 of our beloved Internal Revenue Code, depends on various factors such as the use of the loan proceeds and the borrower’s financial situation at the time the COD event occurs.
One exception provides that you can exclude COD income to the extent you are insolvent when the COD event occurs (the so-called insolvency exception). You are insolvent when your liabilities exceed the fair market value of your assets immediately before the COD event. Another exception applies to debts that are discharged in bankruptcy proceedings (the so-called bankruptcy exception).
Another exception stipulates that COD income from certain forgiven student loans is excludable. To qualify for this exception, the loan document must state that all or part of the student loan debt will be cancelled if you as the borrower work for a certain period of time in a specified profession for a specified type of employer (basically, a public service requirement).
Super-taxpayer-friendly American Rescue Plan Act provision
For 2021-2025, the American Rescue Plan Act (ARPA) grants federal-income-tax-free treatment to full or partial discharges of the following types of student loans:
(1) loans provided expressly for post-secondary educational expenses if the loan was: made, insured, or guaranteed by: the United States, or an instrumentality or agency thereof; a State, territory, or possession of the United States or the District of Columbia, or any political subdivision thereof; or an educational institution as defined for purposes of the federal income tax credits for higher education expenses;
(2) any private education loan as defined by the Truth in Lending Act; and
(3) loans made by educational institutions that qualify as charities for purposes of the federal income tax itemized deduction for charitable donations.
Example 1: Last year, you received the good news that your $30,000 student loan, which was insured by the federal government, was forgiven. Thanks to the ARPA provision, this was a federal-income-tax-free event for you. So, you’ll owe nothing extra to Uncle Sam with your 2021 Form 1040.
Department of education federal student loan discharge procedures
Under the Defense to Repayment procedure, the Department of Education (DOE) is required to discharge certain federal student loans if the student (borrower) establishes, as a defense against repayment, that the school’s actions would give rise to a cause of action against the school under applicable state law. While there is no statutory provision that specifically allows federal-income-tax-free treatment for COD income that results when loans are discharged under the Defense to Repayment procedure, a student loan borrower may be able to exclude COD amounts under other tax-law exceptions, such as the ARPA provision explained above, the insolvency exception, the bankruptcy exception; or under IRS-provided non-statutory exceptions that are issued from time to time.
Under the Closed School procedure, the DOE can discharge a federal student loan when the student was attending a school at the time it closed or if the student withdrew within a certain period before the closing date. There’s a statutory exclusion from taxable gross income for COD income from federal student loans that are discharged under the Closed School discharge procedure. Therefore, a borrower whose loan is discharged under this procedure should not report the related COD income as taxable gross income on his or her Form 1040. See here for more details.
Tax-free treatment for employer Section 127 plan payments towards employee student loans
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) allowed federal-income-tax-free treatment for payments made by employer-sponsored Section 127 educational assistance plans towards student loan debts of participating employees. Between 3/28/20 and 12/31/20, up to $5,250 per-employee per year could have been paid out towards your student loan principal and/or interest with no federal income tax hit for you. Your company could deduct the payments. Nice!
The later Consolidated Appropriations Act, 2021 (CAA) included the Taxpayer Certainty and Disaster Tax Relief Act (TCDTRA). The TCDTRA extended the aforementioned favorable treatment for qualifying student loan debt payments made under employer Section 127 plans through 12/31/25.
Example 2: This year, you receive the good news that your company’s Section 127 plan will pay $5,250 towards your student loan obligations. This is a federal-income-tax-free event, and you’ll owe nothing extra to Uncle Sam with your 2022 Form 1040.
Tax treatment of other employer payments towards employee student loans
Apparently, it’s becoming a more common compensation practice for employers to pay off student loans incurred by their employees. When that happens, it is not a COD event. Instead, it’s a garden-variety taxable compensation event. Student loan amounts that are paid off by your employer are simply treated as additional salary compensation amounts received by you (the student loan borrower). As such, these amounts are subject to federal income and employment taxes and possibly state income tax depending on where you live.
Example 3: In response to the Great Resignation threat, your company announced it would pay up to $10,000 towards student loan balances of eligible employees. If you are lucky enough to qualify for this deal, the $10,000 payment will count as additional 2022 taxable income with the tax results explained above. We’ll take it!
The bottom line
You or a loved one may benefit or have already benefitted from discharges of student loans or payoffs by employers. You now understand the federal income tax implications. Onward.