Student loan debt forgiveness may come with a tax bill

Since President Biden made the decision to forgive student loan debt for some Americans, Bridgette Gephart and her husband say they will probably not be able to enjoy their usual tax refund, because they’ll have to pay state taxes on their debt relief.

Gephart borrowed $45,000 to receive her undergraduate and graduate degree. “The total right now is up to $80,000, because it accumulates $8,000 of interest every year, even though I make payments,” Gephart said.

Gephart and her husband both qualify for $20,000 of student debt relief under Biden’s executive action, but as residents of Indiana, they will have to pay taxes on it. “Our whole federal tax refund will go to pay this Indiana state tax now, which previously we would have used to help pay for the kids,” Gephart told to Yahoo News.

With their twin boys, the Gepharts, like many Americans, has struggled because of student debt. “Like, even though we've worked really hard, I just feel like I can't get ahead,” she said.

According to the Student Debt Crisis Center, Americans owe more than $1.5 trillion in student debt — more than credit card debt and auto loan debt.

To help relieve borrowers, Biden announced last month that he would cancel $10,000 in student loan debt for borrowers who make less than $125,000 a year. Pell Grant recipients would be eligible for an additional $10,000 in forgiveness.

Biden said that 95% of borrowers, or around 43 million people, would benefit from the relief — but that some will have to pay taxes on it. “This is because historically, at both the federal and the state level, any sort of debt relief or debt forgiveness is actually taxable income,” Jared Walczak, the vice president of state projects at the Tax Foundation, told Yahoo News.

However, to prevent borrowers from being taxed federally, the government decided that any student loan debt forgiveness would not be taxable from 2021 through 2025, under a provision from the American Rescue Plan of 2021.

“Some states follow [the provision made under the American Rescue Plan], in fact, most do. But there are a handful of states that don't fully conform to the federal code or don't conform to this provision, and therefore, they're going to tax student loan debt discharge,” Walczak said.

Currently, a handful of states plan to tax student loan debt forgiveness. Walczak said for many of those states, it's just an accident. “They basically follow the old standard practice of debt forgiveness being taxable and aren't including the new federal provision that says this is an exception,” he explained.

At least seven states plan to tax student loan debt forgiveness, including Arkansas, California, Indiana, Minnesota, Mississippi, North Carolina and Wisconsin. Over 8 million federal student loan borrowers live in one of the states that will tax debt relief, according to federal data from March 2022.

The Tax Foundation predicts that the average American will owe roughly $500 on $10,000 student loan forgiveness and $1,000 on $20,000 student loan forgiveness. But, “for most borrowers, if you get $10,000 in loan forgiveness and you pay $500, it's still a deal you'll take,” Walczak said.

Cody Hounanian, the executive director of the Student Debt Crisis Center, has been on the frontlines pushing to get student debt erased for years.

Even though some states will tax debt forgiveness, Hounanian told Yahoo News this relief is a win for borrowers. “It’s going to change the lives of tens of millions of Americans. I mean, 40 million Americans are going to have some student debt canceled, 20 million are going to see their debt completely erased, that is a huge first step,” he said.

But Hounanian says this win is just the beginning, explaining that “if we have to turn our focus to state governments to try to prevent unnecessary taxes, we will do that as well. The fight continues.”

Now, the Student Debt Crisis Center is working with advocates and policymakers to remove state taxes on student debt relief, but states must move quickly if they want to change their policies.

“There's a narrow window for them to act in the states,” Walczak explained. “The legislature is not currently in session, they'll all come in next January. But they have a narrow window, because people start filing their tax returns pretty early. Each of these states has, like the federal government, an April 15 deadline, but many people are filing way before that. So if there's going to be action, it has to happen very quickly.”

Walczak said the Tax Foundation is pushing for borrowers to get prepared. “You need to recognize that this could happen, at least in some states, and you need to be on top of it,” he said.

Most importantly, tax experts suggest that borrowers who plan to receive relief must pay attention to details, because the relief plan and its effects are complex. Walczak says that many borrowers in states that levy taxes on debt relief might not report it as income, “because it's not necessarily clear."

“When you go to file your taxes in the states,” he added, "there's not going to be a line that says student loan debt forgiveness at the federal level. You need to know to include it in your income. So this is where tax preparers come into place. This is where reading closely comes into place.”

For Gephart, a first-generation college graduate, paying taxes on debt forgiveness will be a challenge. “We feel that no borrower who receives student debt cancellations should be taxed by their state or local governments. And, frankly, we're going to work really hard to make sure that's the case,” Hounanian said.