Tax Implications of Federal Loan Forgiveness

Currently, federal student loan debt has reached an excess of $1.5 trillion. More than 7.3 million former students are on various payment plans. There are limited circumstances in which student loan debt can be discharged or forgiven without tax implications. The importance of understanding the tax implications applicable to student loan forgiveness programs and discharge options is more crucial than ever.

Under Internal Revenue Code (IRC) section 61(a), “Gross income included from discharge of debt of $600 or more is considered taxable income in the year of discharge.” This means most taxpayers’ discharged debt will be treated as income for tax purposes. Various exclusionary circumstances provide exceptions to this rule.

Loan Forgiveness Due to Your Job

Canceled student loan debt can be excluded from ordinary taxable income if a “qualified lender” made a loan to assist in attending an “eligible educational institution.” The loan must contain a provision providing total or partial debt cancellation when working for a specified duration within certain professions referenced in IRC section 108(f)(1).

This multipart inquiry includes determining if a borrower:

1. Attended an eligible educational institution. An “eligible educational institution” is one that maintains a regular faculty, curriculum, and normally has an enrolled student body in attendance where educational activities occur;
2. Received a loan from a qualified lender. “Qualified lenders” include federally based loans, public benefit corporations, and nonprofit organizations exempt under IRC section 501(c)(3), or loans made by an eligible educational institution; and
3. Is eligible for student loan forgiveness related to public or nonprofit employment for a specified duration within certain professions as referenced in IRC section 108(f)(1).

Loan forgiveness applicable under section 501(c)(3) includes organizations operated exclusively for the following purposes: charitable, religious, educational, scientific, literary, public safety testing, fostering national or international amateur sports competition, or prevention of cruelty to children or animals. If the borrower works for the prescribed period for one of these institutions, his or her canceled debt may be considered nontaxable. Public service and teacher loan forgiveness are the most well-known loan forgiveness programs in this category. Borrowers hoping to benefit from these programs must strictly adhere to program requirements like employment for a specified number of years, repayment of debt for 10 years, and adherence to loan program qualifications. There is little gray area here. For example, student loans canceled by educational institutions in exchange for service is considered taxable.

Total Disability

There is generally no way to obtain the cancellation of private loans absent a borrower’s permanent and total disability under section 140(7) of the Consumer Credit Protection Act. Under this standard, debt discharged due to death or permanent and total disability will be nontaxable as income when discharged after December 31, 2017.

School Closure

Discharged debt due to school closure will be tax-free. Borrowers are eligible if they are actively enrolled, on a leave of absence, or the school closure occurs within 120 days of withdrawal. Borrowers become ineligible for this benefit if they complete a similar education program elsewhere or if all program coursework is completed before the closure, even absent receipt of a diploma or certificate. Like other discharge options, borrowers must contact the loan servicer to initiate the loan forgiveness or cancellation process.

Loan Repayment Program

The most common student loan payment program is income-based repayment. Unlike loan forgiveness or discharge, cancellation of remaining debt after 20–25 years of payments in an income-driven repayment plan is considered taxable income to the borrower in the year discharged under current law. Similarly, this requires compliance with all components of the repayment plan and is restricted to federal loans.