The tax break on college debt cancellations in the COVID-19 relief package signed last week by President Joe Biden has removed a potential roadblock to forgiving student loan debt: taxes.
The provision won’t count any debt forgiven from Dec. 31, 2020, to Jan. 1, 2026, as income. Under one of the existing forgiveness programs (income-driven repayment), the amount forgiven is reported to the IRS as income and taxed according to the borrower’s current tax bracket.
Any debt forgiveness wouldn’t benefit borrowers if it led to an unaffordable tax bill, says Douglas Webber, associate professor of economics at Temple University.
“I see this as one step closer to eliminating what would be not just a big potential downside, but a big public relations problem,” Webber says.
The tax measure was adapted from the Student Loan Tax Relief Act spearheaded by Sens. Bob Menendez, D-N.J., and Elizabeth Warren, D-Mass. On March 6, Warren tweeted, “This clears the way for President Biden to #CancelStudentDebt without burdening student borrowers with thousands of dollars in unexpected taxes.”
Experts say the tax relief measure could do just that.
“Given the context and all the discussions about loan forgiveness, I think it’s likely that this is a nod from Congress to open up this door,” says Megan Coval, vice president of policy and federal relations at National Association of Student Financial Aid Administrators.
Artem Gulish, senior policy strategist at Georgetown University Center on Education and the Workforce, says the relief package was just a start for student loan borrowers.
“This is the first thing the Biden administration is putting through; there is still the potential for forgiveness,” Gulish says.
However, there still isn’t legislation or executive order that answers the big questions of “if,” “how much,” or “when” forgiveness could happen.
What your bill could look like without a tax break
Imagine there was no tax relief included in the stimulus package. Optimistically, let’s also look into a crystal ball and say you have $10,000 of student loan debt forgiven sometime this year. Your earnings are $68,000 (the approximate median in the U.S.), which means you fall within the 22% tax bracket. Next year when you pay taxes on 2021 income, the forgiven debt would be taxed at 22% and you would owe $2,200 on it.
Without a tax break, forgiveness could also have pushed you into a higher tax bracket. Say you earned $85,525 — the high end of the 22% tax bracket — and had $10,000 forgiven, which pushed you into the next bracket. Since it’s a progressive tax system, you would end up paying 22% on your income, but 24% on that amount that spilled over into the higher tax bracket ($2,400 in this example).
There are additional sacrifices on the lower end of the income spectrum, says Erica Blom, a senior research associate at the Urban Institute, a nonprofit research organization. Sliding into a different tax bracket could result in loss of credits, such as the earned income tax credit or a child tax credit.
“That could have been as bad or worse than asking someone to cough up an additional $1,000 in taxes,” Blom says.
Where student loan forgiveness stands
Democratic lawmakers, a group of 17 state attorneys general and consumer rights advocates have all called on Biden to cancel up to $50,000 in federal student loans via executive order.
The president has said that he backs $10,000 in blanket forgiveness for federal student loan borrowers through congressional action. During a CNN town hall on Feb. 16, he said that he doesn’t support $50,000 of forgiveness.
Biden and his team have questioned whether he has the authority to call on the Department of Education to forgive debt through executive action. Advocates argue a president does have this power under the Higher Education Act. However, the Department of Education issued a legal memo in January stating that its secretary lacks authority to issue forgiveness.
The 42.9 million federal student loan borrowers who collectively owe $1.57 trillion to the federal government stand to benefit from blanket forgiveness. Having $10,000 forgiven would wipe out debt entirely for 15 million student loan borrowers, according to a NerdWallet analysis of federal student loan data.
Neither forgiveness proposal would presumably benefit borrowers with private student loans or those with commercially held Federal Family Education Loan debt, who were left out of previous relief packages. However, the tax relief for forgiven debt could benefit private student loan borrowers whose debts are settled via bankruptcy.
Meanwhile, federal student loan borrowers remain in an interest-free payment pause that began March 13, 2020, and extends through the end of September.
Existing forgiveness plans and taxes
Although there are existing debt cancellation programs, the success rates and tax implications have varied. Public Service Loan Forgiveness offers tax-free debt cancellation for borrowers who are approved (only 2.2% of applicants have been so far, according to federal data). Loan amounts forgiven under Borrower Defense to Repayment — used if you’ve been defrauded by your school — aren’t taxed. And disability forgiveness also isn’t considered taxable income.
Forgiveness is normally taxed for those enrolled in an income-driven repayment plan, which sets payments at a portion of your income and forgives debt after 20 or 25 years. So far, only 32 borrowers have received forgiveness through these repayment programs, according to March 2021 data obtained by the National Consumer Law Center.
But most borrowers currently enrolled in an income-driven repayment plan won’t be eligible to benefit from forgiveness until 2035 at the earliest — well after the Jan. 1, 2026, expiration date on the tax-free provision in the new relief package.
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The article COVID Tax Break Could Open Door to Student Loan Forgiveness originally appeared on NerdWallet.
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