According to a recent estimate, the total amount of student debt outstanding is approximately $1.75 trillion. Of this amount, federal student loans total approximately $1.59 trillion. According to the same source, about 43.2 million student borrowers owe an average of just over $39,000 each. That’s a lot of debt!
The good news is that, in some cases, student loan balances can be forgiven or even paid off by an employer. This column focuses on the resulting federal tax consequences for student borrowers who are lucky enough to have this happen. The lucky borrower may not be you, but it could be a loved one. Anyway, here it is.
Debt Cancellation (COD) Income Tax Basics
The general federal income tax rule states that a taxpayer’s gross income includes debt cancellation income (COD), unless a statutory exception applies. The availability of these exceptions, which are found in Section 108 of our beloved Internal Revenue Code, depends on various factors such as the use of the loan proceeds and the financial condition of the borrower at the time the event COD occurs.
An exception provides that you can exclude COD income to the extent that you are insolvent when the COD event occurs (the so-called insolvency exception). You are insolvent when your liabilities exceed the fair market value of your assets immediately before the COD event. Another exception applies to debts that are paid in bankruptcy proceedings (so-called exception of bankruptcy).
Another exception states that COD income from certain canceled student loans is excluded. To qualify for this exception, the loan document must state that all or part of the student loan debt will be forgiven if you, the borrower, work for a certain period of time in a specified occupation for a specified type of employer ( essentially, a public need for service).
Taxpayer-friendly super-friendly American Rescue Plan Act provision
For 2021-2025, the American Rescue Plan Act (ARPA) provides federal income tax exempt treatment to full or partial discharges of the following types of student loans:
(1) loans made expressly for post-secondary education expenses if the loan was: made, insured, or guaranteed by: the United States, or an agency or agency thereof; a state, territory or possession of the United States or the District of Columbia, or any political subdivision thereof; or an educational institution as defined for purposes of federal income tax credits for higher education expenses;
(2) any private education loan as defined by the Truth in Lending Act; and
(3) Loans made by educational institutions that are considered charities for the purposes of the itemized federal income tax deduction for charitable donations.
Example 1: Last year, you received the good news that your $30,000 student loan, which was federally insured, was forgiven. Thanks to the ARPA provision, this was a federal income tax-free event for you. So you won’t owe Uncle Sam anything more with your 2021 Form 1040.
Department of Education Federal Student Loan Discharge Procedures
Under the Reimbursement Defense procedure, the Department of Education (DOE) is obligated to discharge certain federal student loans if the student (borrower) establishes, as a defense to repayment, that the school’s actions would give rise to a cause of action against the school under applicable state law. Although no statutory provision specifically authorizes federal income tax-free treatment for COD income resulting from the cancellation of loans under the repayment defense proceeding, a student borrower may be in able to exclude COD amounts under other tax law exceptions. , such as the ARPA provision explained above, the insolvency exception, the bankruptcy exception; or under non-statutory exceptions provided by the IRS that are issued from time to time.
Under the School closed procedure, the DOE can cancel a federal student loan when the student was attending a school at the time of its closing or if the student withdrew within a certain period of time before the closing date. There is a statutory taxable gross income exclusion for COD income from federal student loans that is discharged under the closed school discharge process. Therefore, a borrower whose loan is discharged under this procedure should not report the corresponding COD income as gross taxable income on their Form 1040. See here for details.
Tax-exempt treatment for employer’s Section 127 plan payments for employee student loans
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) has authorized federal income tax-free treatment for payments made by the Education Assistance Plans of the employer-sponsored Section 127 student loan debt for participating employees. Between 3/28/20 and 12/31/20, up to $5,250 per employee per year could have been paid out of your student loan principal and/or interest without you having to pay federal income tax. Your business could deduct the payments. Pleasant!
The latest Consolidated Credits Act (CAA) of 2021 included the Taxpayer Certainty and Disaster Tax Relief Act (TCDTRA). The TCDTRA has extended the aforementioned favorable treatment for qualifying student loan repayments made under employer Section 127 plans through 12/31/25.
Example 2: This year, you receive the good news that your company’s Section 127 plan will pay $5,250 toward your student loan obligations. This is a federal non-income tax event, and you won’t owe Uncle Sam anything extra with your 2022 Form 1040.
Tax treatment of other employer payments for employee student loans
Apparently, it’s becoming a more common compensation practice for employers to repay student loans taken out by their employees. When this happens, it is not a COD event. Instead, it is a garden variety taxable compensation event. Student loan amounts that are repaid by your employer are simply treated as additional salary compensation amounts that you (the student loan borrower) receive. As such, these amounts are subject to federal income and employment tax and possibly state income tax depending on where you reside.
Example 3: In response to the big resignation threat, your company announced it would pay up to $10,000 for eligible employees’ student loan balances. If you are lucky enough to qualify for this offer, the $10,000 payment will be considered additional 2022 taxable income with the tax results explained above. We will take it!
The bottom line
You or a loved one can benefit or have already benefited from student loan releases or repayments by employers. You now understand the federal income tax implications. Forward.