Shortly after signing the Inflation Reduction Act into law, President Biden announced his plan to use executive action to cancel up to $10,000 of student loan debt for borrowers under certain income thresholds and an additional $10,000 for borrowers who received Pell Grants. Some support this action, while others condemn it and threaten lawsuits. While nothing is certain until the ink is dry, let’s assume that forgiveness occurs and an estimated 43 million borrowers receive this relief. For the curious, that’s roughly 13% percent of the population of the United States as a whole. No matter how you slice it, that’s a staggering number of individuals affected. Many might wonder how this reduction will affect their taxes.
Internal Revenue Code (“Code”) Section 61(a)(12) specifically includes income from the discharge of indebtedness (cancellation of debt or “COD”) as gross income. Sounds simple enough, but those familiar with the Code know that for every rule, at least one exception exists. In fact, the Code contains several provisions that exclude COD from gross income. Code Section 108(a)(1) indicates that income does not include discharge of indebtedness income if the discharge occurs: (1) in a title 11 bankruptcy reorganization; (2) when the taxpayer is insolvent; (3) the discharged debt is farm indebtedness; (4) for a taxpayer other than a C Corporation, if the discharged indebtedness is qualified real property business debt; or (5) if the indebtedness discharged is qualified personal residence indebtedness discharged before January 1, 2026, or subject to an arrangement entered into and evidenced in writing before January 1, 2026. Excluding COD from gross income comes at a price and doing so usually reduces or eliminates other tax attributes such as basis in property, or loss of credit carryovers. See Code Section 108. Code Section 1017 includes details regarding reductions in basis. The foregoing Code provisions indicate that those taxpayers who receive a partial (or complete) loan reduction will have COD income in the amount forgiven and may lose other valuable tax attributes which arguably defeats the purpose of the forgiveness.
In certain cases, debtors with low income have additional repayment options designed to accommodate lower income. One such program, the income-driven repayment (IDR) plan works like it sounds. The borrower in an IDR plan makes monthly payments based upon their income. Usually, the amount of interest accrued each month on the loans exceeds the borrower’s income resulting in COD for the borrower which undercuts the purpose of lowered payments for lower income. Fortunately for those borrowers, the American Rescue Plan Act (ARPA) of 2021 exempted student loan forgiveness under IDR plans from inclusion in gross income through 2025. According to whitehouse.gov, ARPA eliminates the need for borrowers to include forgiveness of student loan debt under Biden’s plan in their gross income as well, even if they are not paying under an IDR plan.
As of the writing of this article, student loan borrowers benefitting from President Biden’s loan forgiveness should not have to include the income from such discharge in their gross income. However, that could change so it’s important to keep updated on this plan as it develops. It’s possible that some of your clients, or more likely their children or grandchildren, may benefit on some level from this program. As such, familiarize yourself with the requirements to achieve loan forgiveness and the potential impact it will have on a client’s income taxes. It seems that the Department of Education plans to make additional changes in the future, so this story will continue to develop.
Tereina Stidd, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
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