Relief from Student Loan Debt: What Are the Tax Implications?
Today's college students often leave school with an overwhelming amount of debt. In some cases, student loans are discharged (also known as being cancelled or forgiven). In other cases, these loans are paid off by an employer. Both actions have tax consequences for the student loan borrowers. We'll explain the tax implications, but first, let's cover some necessary background information.
Cancellation of Debt Tax Basics
For federal income tax purposes, the general rule is that a taxpayer's gross income includes any cancellation of debt (COD) income — unless one of several tax-law exceptions applies. The availability of exceptions (found in Section 108 of the Internal Revenue Code) depends on various factors such as the use of the loan proceeds and the borrower's financial condition at the time the "COD event" occurs.
Here are some of the exceptions:
- The insolvency exception. Taxpayers can exclude COD income to the extent they are insolvent when the COD event occurs. Taxpayers are insolvent when their liabilities exceed the fair market value of their assets immediately before the COD event.
- The bankruptcy exception. This applies to debts that are discharged in bankruptcy proceedings.
- The public service employment exception. COD income from certain forgiven student loans is excludable. To qualify, the loan document must state that all or part of the student loan debt will be cancelled if the student works for a certain period of time in a specified profession for a specified type of employer. Basically, this is a public service requirement. For example, some teachers who work for five years at a school that serves low-income families may be eligible for forgiveness on up to $17,500 of certain federal loans.
Department of Education Loan Discharge Procedures
There are also some non-tax-law provisions that allow student loan borrowers to exclude COD income when the U.S. Department of Education discharges federal student loans. For this purpose, federal student loans include federal Family Education Loans, federal Perkins Loans and federal Direct Loans. For example:
The closed school procedure. The Department of Education can discharge a federal student loan when the student was attending a school at the time it closed or if the student withdrew within a certain period before the closing date. COD income from federal student loans that are discharged in this situation are tax-free and shouldn't be reported as taxable gross income on the borrower's federal income tax return.
The defense to repayment procedure. Under this procedure, the Department of Education is required to discharge a federal Direct Loan if a student borrower establishes, as a defense against repayment, that the school's actions would give rise to a cause of action against the school under applicable state law. Federal Family Education Loans can also be discharged under this procedure if certain additional requirements are met.
There's no statutory rule that provides tax-free treatment for COD income from loans that are discharged under this procedure. But the taxpayer (student loan borrower) may be able to exclude COD income amounts under other tax-law exceptions (such as the aforementioned insolvency exception or bankruptcy exception) or under an IRS-approved nonstatutory exception (such as the one for Corinthian College student loan borrowers, as explained below).
Two College Cases and Tax Relief for Student Borrowers
The Department of Education discharged federal student loans that were taken out to finance attendance at schools owned by Corinthian Colleges, Inc. (CCI). The government estimated that more than 50,000 borrowers may be eligible for discharges under this program. The discharges are made under the Closed School or Defense to Repayment discharge procedures, based on misrepresentations made by the school.
CCI was the subject of multiple federal and state investigations regarding whether it misled students about its financial condition and its job placement rates. CCI sold more than half of its campuses in late 2014 and then abruptly closed its remaining schools in April of 2015. These actions left some 16,000 students in limbo. CCI filed for bankruptcy in May of 2015. Afterwards, the Department of Education announced federal student loan relief for affected students.
In IRS Revenue Procedure 2015-57, the agency states that taxpayers who took out federal student loans to attend schools owned by CCI qualify for tax relief if the loans are discharged under the Department of Education's Closed School or Defense to Repayment procedures. These taxpayers don't need to recognize taxable gross income as a result of the discharges. The IRS also states these taxpayers aren't required to increase their federal income tax or taxable income to account for higher education tax credits, deductions for tuition and fees, and deductions for college loan interest that were claimed based on expenses financed by the discharged loans.
In another case in 2017, The IRS provided that taxpayers who took out federal student loans to attend schools owned by American Career Institutes, Inc., and whose loans were discharged under the Education Department's Closed School or Defense to Repayment processes, won't have to recognize gross income on their tax returns. The IRS also stated these taxpayers won't be required to increase their taxes or income to account for education credits, interest deductions or education expense deductions claimed from proceeds of these loans. (IRS Revenue Procedure 2017-24)
Student Loans Paid Off by Employers
Some employers pay off all or a portion of student loans incurred by their employees as a fringe benefit. These loan payoff programs are often conditional on the employee working for the employer for a certain number of years.
When an employer makes payments on behalf of an employee, it's not a COD event. Instead, it's taxable compensation. Student loan amounts that are paid by employers are simply treated as additional salary received by the affected employee. As such, these amounts are subject to federal income and employment taxes and possibly state income tax too.
The Bottom Line
You or someone you know may have benefited from discharges of federal student loans. If your employer pays off your federal student loans, that's a great fringe benefit. However, it's not necessarily good news from a tax perspective. That's why it's important to understand both the advantages and possible negative consequences of student loan discharges.
If you have questions or want more information about the tax implications of student loans and student loan debt relief, contact your tax adviser.