Student Loan Forgiveness Tax Guidelines

There was much buzz and excitement about the Biden administration’s loan forgiveness program from some quarters, and concern from others, when the program was first announced. Legal challenges have halted student loan forgiveness in its tracks, even though some applications have been approved. While we wait to see what will happen in the courts, let’s take a moment to talk about what student loan forgiveness could mean in the context of your income tax bill.

What is Student Loan Forgiveness (and How Could it Be Taxed)?

The federal student loan forgiveness program announced in 2022 would allow individual borrowers who make up to $125,000 per year to have up to $10,000 of their student loan debt forgiven—completely wiped out. Married couples filing their income taxes jointly qualified for forgiveness if their income was $250,000 or less. And Pell Grant recipients (who typically have exceptional financial need) were eligible for up to $20,000 in student loan forgiveness.

For many borrowers, especially low earners, the news of forgiveness felt like a crushing weight had been removed from their shoulders. Instead of using their earnings to pay back loan debt, those dollars would be available to save, pay other bills, or simply have a better quality of life.

But in some situations, the forgiveness of a loan is considered income. It is the same as if someone had handed you $10,000 to pay off a loan. If $10,000 in income can be taxed, could student loan forgiveness be taxed, too? Theoretically, yes—but as usual with tax questions, the answer is a little complicated

Will Student Loan Forgiveness Be Taxed?

One question we heard from many clients when the possibility of forgiveness was announced was whether they, or their adult children, might have to pay tax on the forgiveness of a student loan. This question might be moot if legal challenges to the program succeed, but it’s worth answering since the ultimate fate of student loan forgiveness is still uncertain.

The short answer is that student loan forgiveness is not taxable for purposes of federal income tax. That’s because the American Rescue Plan Act (ARPA) signed into law by President Biden paused taxes on student loan forgiveness between 2021 and 2025. After 2025, forgiveness of a student loan could potentially be treated as taxable income on a federal tax return—but there’s a lot that could happen between now and then. For the moment, if student loan forgiveness proceeds, forgiveness will not be taxed as income at the federal level.

But remember that state taxing authorities often have different rules, and in some states, a forgiven loan amount will be treated as income for purposes of taxation, even before 2025.

States taxing student loan forgiveness would include:

• Arkansas
• California
• Indiana
• Minnesota
• Mississippi
• North Carolina
• Wisconsin

If you live in one of the states listed above, you should consider consulting a tax preparation professional to learn what your tax responsibility could be if and when the federal student loan forgiveness program finally does move forward.

Why might some states, but not others, treat student loan forgiveness as taxable income? The answer has to do with the concept of conformity. Many states have laws in place that conform their tax treatment of assets, debts, and various types of income to that of the federal government. So if the federal government states that “X income is not taxable on a federal income tax return,” it won’t be at the state level, either. The states above do not conform their tax laws to federal tax laws, at least in this instance. Ohio does conform its tax law with federal tax law on the issue of the taxability of student loan forgiveness.

How Much Tax Could You End Up Paying on Student Loan Forgiveness?

Assuming that student loan forgiveness moves forward, and you live in a state that is likely to tax that forgiveness, how much might you end up paying? Estimates, depending on the state, range from $300 to $1100. Federal student loan forgiveness is taxed at your regular income tax rate. When—and if—some borrowers might have to pay tax on forgiveness of loans is unclear. For now, at least, the issue is on hold, and student loan forbearance has been extended into 2023.

The Bottom Line

If you are a student loan borrower, you will want to keep your eye on legal development to see whether the federal government will be able to forgive a portion of your federal student loans. If student loan forgiveness is allowed to proceed, chances are you will not be taxed on student loan forgiveness. Even if you would be subject to tax, the benefit is probably worth it. To learn more about whether student loan forgiveness is taxable, schedule an appointment today with the accounting and tax preparation professionals at Gudorf Tax Group.