Student loan forgiveness is often looked at as a quick solution for borrowers to escape the financial burden of large student loan balances. What are the hidden costs of student loan forgiveness?
What many people aren’t aware of, though, is that the forgiven balances can often be considered taxable income by the Internal Revenue Service - leaving borrowers whose loans have been forgiven to face a hefty tax bill.
What you need to know:
Many borrowers are relieved to learn about income-driven repayment plans, like Pay as You Earn, which cap monthly student loan payments at ten to 15 percent of a borrower’s monthly income. When partnered with student loan forgiveness, the remaining balance after making payments for a predetermined period, usually between 20 and 25 years, is forgiven.
This balance, under IRS standards, is taxable income - and borrowers who combine these programs might be surprised to see a significant tax bill when the loans are forgiven.
Lenders will send both the borrower and the IRS a 1099-C form, which, among other things, reports forgiven debts.
For example, a borrower might have $40,000 in student loan debt forgiven after making consistent payments for 20 years. Even though the $40,000 does not require repayment, it will be included on the 1099-C form - meaning that a federal tax bill on this forgiven debt could exceed $10,000. State income taxes may also be owed on this amount.
Current tax law only exempts taxation of loans forgiven through Public Service Loan Forgiveness and Student Loan Forgiveness for Teachers. Borrowers who are unable to pay the bill in full may be required to set up a payment plan with the IRS. Should the borrower take no action, they may also face a penalty and interest on the debt.
What does the future hold?
As representatives and leaders learn about this situation, some are running with the idea of changing the current tax law. One such step is the Relief for Underwater Student Borrowers Act, which would allow exemption from taxes on forgiven loans for borrowers in good standing.
Introduced by US Representatives Mark Pocan and Frederica Wilson, the bill would close “a major gap in our tax code which penalizes some borrowers who have been granted debt relief after at least 20 years of consistent repayment towards their student loan debt,” Pocan notes.
While this bill seems to remedy the possible tax situation for many student loan borrowers, it has not yet been passed, making it even more important to follow our blog for the latest information on student loan reform.