On August 24, 2022, President Joe Biden issued an executive order to help provide relief to nearly 95% of U.S. residents who are burdened by student loan debt. The most significant announcement was that the U.S. Department of Education will provide up to $20,000 in debt cancellation to Pell Grant recipients with loans held by the Department of Education, and up to $10,000 in debt cancellation to non-Pell Grant recipients. Borrowers are eligible for this relief if their individual income is less than $125,000 ($250,000 for married couples). Current students with loans are eligible for this debt relief. Furthermore, borrowers who are dependent students will be eligible for relief based on parental income, rather than their own income. Finally, any borrowers who have made payments since the pandemic-related pause on federal student loan payments began March 13, 2020 can request a refund for those payments.
What are the tax consequences for forgiven debt? Generally, 26 U.S.C. §61(a)(12) of the Internal Revenue Code states “gross income means all income from whatever source derived, including… [i]ncome from discharge of indebtedness.” This means that when you have debt that is forgiven or discharged for less than the full amount owed, then you must claim as ORDINARY INCOME the amount you didn’t have to repay on your tax return. As a result, you generally have to pay taxes on the cancelled amount. If a financial institution, federal agency or credit union cancels or forgives debt of $600.00 or more, you will receive a Form 1099-C (Cancellation of Debt) and it will also be reported to the IRS by January 31 of the following year. In most cases, failing to report income from cancelled and forgiven debt can lead to interest and penalties due.
Do these cancelled debt provisions apply to President Biden’s student loan relief? Fortunately, borrowers will not be liable for any amount of the student loan debt forgiveness on their federal income tax returns, but they may have tax consequences on their state income tax returns.
STUDENT LOAN FORGIVENESS NOT TAXABLE INCOME UNDER THE AMERICAN RESCUE PLAN ACT OF 2021
On March 11, 2021, President Biden signed the American Rescue Plan Act of 2021 into law that provided ongoing economic relief as the country moves from the devastating financial effects of the COVID-19 pandemic. Section 9675 of the American Rescue Plan Act provides an amended Paragraph 5 to 26 U.S.C. §108(f) of the Internal Revenue Code addressing modifications to the taxability of student loan forgiveness as follows:
(5) Special rule for discharges in 2021 through 2025.– Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) after December 31, 2020, and before January 1, 2026, of—
- (A) any loan provided expressly for postsecondary educational expenses, regardless of whether provided through the educational institution or directly to the borrower, if such loan was made, insured, or guaranteed by—
- (i) the United States, or an instrumentality or agency thereof,
- (ii) a State, territory, or possession of the United States, or the District of Columbia, or any political subdivision thereof, or
- (iii) an eligible educational institution (as defined in section 25A),
- (B) any private education loan (as defined in section 140(a)(7) of the Truth in Lending Act),
- (C) any loan made by any educational organization described in section 170(b)(1)(A)(ii) if such loan is made—
- (i) pursuant to an agreement with any entity described in subparagraph (A) or any private education lender (as defined in section 140(a) of the Truth in Lending Act) under which the funds from which the loan was made were provided to such educational organization, or
- (ii) pursuant to a program of such educational organization which is designed to encourage its students to serve in occupations with unmet needs or in areas with unmet needs and under which the services provided by the students (or former students) are for or under the direction of a governmental unit or an organization described in section 501(c)(3) and exempt from tax under section 501(a), or
- (D) any loan made by an educational organization described in section 170(b)(1)(A)(ii) or by an organization exempt from tax under section 501(a) to refinance a loan to an individual to assist the individual in attending any such educational organization but only if the refinancing loan is pursuant to a program of the refinancing organization which is designed as described in subparagraph (C)(ii).
The amendment made by the American Rescue Plan Act of 2021 to 26 U.S.C. §108(f) shall apply to discharges of loans after December 31, 2020.
The student loan debt forgiven and not considered taxable income not only applies to the current relief provided by President Biden in August 2022 but to any future student loan forgiveness provided up to December 31, 2025.
THE STATE OF MICHIGAN REQUIRES INCOME TAX TO BE PAID ON FORGIVEN STUDENT LOAN DEBT UNDER CURRENT LAW
The American Rescue Plan Act of 2021 applies only to federal income taxes, not income taxes assessed by any of the individual states and territories of the United States. For those states that do assess income taxes, any forgiven debt is generally considered taxable income where income tax would be owed on the forgiven amount. In Michigan, forgiven student loan debt is considered taxable income and a flat 4.25% tax rate is applied against any taxable income of Michigan residents (after deductions, exemptions and credits). Forgiven student loan debt of $10,000.00 can result in a tax bill up to $425.00.
House Bill No. 4943 was introduced in the Michigan House of Representatives on May 27, 2021 proposing specific changes to Michigan’s Income Tax Act and states: “[f]or tax years that begin on and after January 1, 2021, deduct, to the extent included in adjusted gross income, income reported on a federal income tax form 1099-C that is attributable to the cancellation or discharge of a student loan by the United States Department of Education or the United States Department of Treasury.” This bill remains in committee and has NOT yet been passed by either house of the Legislature or signed by the governor, if at all.
Should the law on the tax treatment of student loan forgiveness change in Michigan, our blog will be updated to reflect those modifications.
OUR TAX PROFESSIONALS ARE HERE TO HELP
If you have further questions about the taxation of forgiven debt or you need legal representation, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.