Taxes: Are Forgiven Student Loans Taxable or Tax-Exempt?By
A forgiven, canceled, or discharged student loan could be exempted from taxable gross income under certain exceptions.
There a variety of reasons where student loans are forgiven, canceled, or discharged, including the borrower’s death or total and permanent disability, a special loan repayment program, or a qualifying borrower’s inability to pay back the loan during a certain time period. Although a debt may be forgiven, the discharged debt amount is still included in the taxpayer’s gross income, per Internal Revenue Code (IRC) §61(a)(11). But there are some exceptions under which the taxpayer may exclude the discharged amount from income as provided in IRC §108(f)(1).
A student loan is any loan provided to a student to help attend a qualified educational organization made by the United States, a state, a territory or other similar government agency, or a public benefit corporation that’s tax-exempt under IRC §501(c)(3); that has taken control of a state, county, or municipal hospital; and whose employees are considered public employees per state law.
Moreover, a student loan includes the loans made as part of a program by a qualified educational organization designed to encourage students to serve in occupations with unmet needs or in areas with unmet needs where the student provides the services under the direction of a governmental unit or a tax-exempt charitable organization described in IRC §501(c)(3). Yet IRC §108(f)(3) states that the cancellation of the loan won’t qualify for tax-free treatment if it was canceled because of services the taxpayer performed for the educational institution that made the loan or other organization that provided the funds.
As a result of the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, the discharge of any amount of the student’s loan after December 31, 2017, and before January 1, 2026, on account of the student’s death or total and permanent disability, is excluded from gross income. Under this tax provision, this discharge also applies to private education loans as well as the other types of student loans already discussed.
Student loan repayments or loan forgiveness programs provided to the taxpayer are tax-free if the education leads the taxpayer to provide healthcare services in areas that are underserved or experiencing a shortage of health professionals. The Public Health Services Act §338 (see IRC §108(f)(4)) specifically identifies the following programs:
- The National Health Service Corps Loan Repayment Program (NHSC LRP),
- A state program eligible for funds under the Public Health Service Act, or
- Any other state loan repayment or loan forgiveness program that’s intended to provide for the increased availability of healthcare services in underserved or health professional-shortage areas (as determined by the state government).
The NHSC LRP offers qualified healthcare providers the opportunity to have their student loans repaid while earning a competitive salary in exchange for providing healthcare in urban, rural, or tribal communities that have limited access to care. NHSC LRP funds are exempt from federal income taxes and employment taxes. They also aren’t included as wages when determining benefits under the Social Security Act. It’s important to note that participants in the NHSC LRP program need to serve in the designated areas as defined by the Secretary of Health and Human Services in order to qualify for the tax-exempt status.
TEACHERS AND PUBLIC SERVICE
Under the Teacher Forgiveness Program, if a qualified educator teaches full-time for five complete and consecutive academic years in a low-income school or an educational service agency, he or she may be eligible for forgiveness of up to $5,000 in the aggregate of the loan obligation and may be able to get up to $17,500 forgiven if he or she specializes in mathematics, science, or special education under Title 20, Education of the United States Code (20 U.S. Code §1078-10 (c)).
A qualified teacher must have been employed at an elementary school, secondary school, or educational service agency that serves low-income students. It’s also required that the school or educational agency be listed in the Teacher Cancellation Low Income (TCLI) Directory that’s published each year by the U.S. Department of Education. In case the school was listed in the first year but not in any of the subsequent years, the remaining years can still be counted toward the requirement of five “complete and consecutive” academic years.
There’s a similar program for those working in public service: the Public Service Loan Forgiveness (PSLF) Program. Created by the College Cost Reduction and Access Act (P.L. 110-84) and effective in 2007, this program was intended to ease the burden of a student loan and to encourage graduates to take a full-time position in qualifying public service jobs, including employment in emergency management, military service, public safety, law enforcement, public health, and government.
But the PSLF has some challenging criteria. It forgives the remaining balance of the Federal Direct Loans after the borrower makes 120 qualifying monthly on-time payments under a qualifying repayment plan. A qualified borrower also must work full-time for an annual average of at least 30 hours a week and, if less than one year, for a contractual or employment period of at least eight months at an average of 30 hours per week. The amount of debt forgiven via the PSLF Program is excluded from taxable income.
The latest forgiveness program is provided by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, which was passed on March 27, 2020. Under §3513 of the CARES Act, payments on federal student loans are automatically suspended and interest won’t accrue. More importantly, payments will be treated as if the borrower made the payment for the purpose of any loan forgiveness program. In addition, the payment will be reported to the credit agencies as if payments were paid when scheduled.
Although the CARES Act doesn’t appear to explicitly state that these payments are tax-exempt, the law implies as written that suspended payments are treated as if paid and thus technically aren’t cancellation of debt income. The CARES Act doesn’t apply to private loans since those aren’t considered federal loans.
The discharge of a student’s loan that meets the qualifying rules is a crucial tax issue to consider for that student’s income tax, especially if a Form 1099-C is received showing cancellation of debt income to the student. Paying back a student loan can be daunting enough, so it’s a welcome tax break if the individual doesn’t have to pay income taxes when some or all of the loan is forgiven.
© 2020 A.P. Curatola