In honor of Financial Literacy Month, we’d like to talk about one of the biggest issues facing many Americans today. It’s no secret that today’s college students often leave school with mountains of student loan debt. There are multiple ways to be relieved of student loan debt, including the debt being paid off as a benefit, forgiven, or discharged due to bankruptcy. No matter the method, it’s important for better financial literacy to understand the potential tax implications when you’re relieved of your student loans.
A fringe benefit now being offered by some employers is student loan payoff assistance, wherein employers payoff some, or all, of an employee’s student loans after a certain number of years of service. From a tax perspective, when these loans are paid off, the paid amounts are treated as taxable compensation, and therefore subject to federal income and employment taxes, and state income tax where applicable. It’s quite the perk to be relieved of your student loans, but the tax implications could be costly.
In other cases, the students may have their loans forgiven. The amounts forgiven generally are added to gross income, but there are exceptions. Some exceptions depend on the borrower’s financial condition at the time the debt was cancelled. If the borrower is insolvent at the time of cancellation of debt, taxpayers can exclude cancellation of debt income. Insolvency is determined if an individual’s liabilities exceed the fair market value of their assets immediately before the debt is cancelled. Another exception is when forgiven student loan debts are discharged during bankruptcy proceedings. Lastly, those who are employed in certain areas of public service can have forgiven student loan debts that are exempt from taxable income. The loan document must specify what type of job, with what employer, and for what length of time to be qualified for this exemption. For example, some federal student loans are forgiven for teachers who serve low-income populations for five years, up to $17,500.
Additionally, federal student loans discharged by the U.S. Department of Education can be excluded from cancellation of debt (COD) income due to provisions not related to tax law. For the following, federal student loans include federal Direct Loans, federal Family Education Loans, and federal Perkins Loans. The Department of Education discharges loans for several reasons, but some that allow the COD income to be excluded are:
• The closed school procedure. When a school closes at the time a student is attending, or had withdrawn within a certain period before its closing, the Department of Education can discharge a federal student loan. In this scenario, the COD income from federal student loans that are discharged is tax-free. This income should not 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/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, explained below).
One College Case and Tax Relief for Student Borrowers
The Department of Education has been discharging federal student loans that were taken out to finance attendance at schools owned by Corinthian Colleges, Inc. (CCI). The government estimates 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 has been the subject of several 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, then abruptly closed its remaining schools in April 2015. This left roughly 16,000 students in limbo. CCI filed for bankruptcy in May 2015, and subsequently 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 taxable income or federal income tax to account for deductions for tuition and fees, higher education tax credits, and deductions for college loan interest that were claimed based on expenses financed by the discharged loans.
The Bottom Line
It’s likely that you or someone you know may have benefited from federal student loan discharges. While a fringe benefit of student loan payoff will relieve you of your student loan debt, it could be costly for you from a tax perspective. It’s crucial to understand both the advantages and possible negative consequences of student loan discharges, forgiveness, and other relief forms. While you navigate this situation, be sure to weigh your options with a trusted professional. For answers to your questions or if you want more information about tax implications of student loans and student loan debt relief, contact your tax advisor at Crippen & Co. today. Taking this step on your path toward better financial literacy will help make your April a successful Financial Literacy Month.