Student Loan Forgiveness Could Mean a Large Tax Bill

There has been a lot of talk surrounding the forgiveness of student loan debt. At the time of this post, student loan debt hovers around $1.6 trillion. Many lawnmakers argue that this debt is stunting the economy and preventing those who carry it from purchasing homes and spending. On average, those with debt have approximately $30,000.

The discussion of forgiving the debt for borrowers has only grown louder. With President Biden now in office, it may be the time for the Democrats, who’s party favors debt forgiveness over Republicans, to act and attempt to pass a forgiveness bill or possibly push something through via executive order. All politics aside, if you may be receiving student loan forgiveness, it’s important to understand the possible tax consequences of this.

Typically, debt cancellation (the tax term for “forgiveness”) is a taxable event. Student loan debt is no exception (at least right now, anyway). Upon cancellation, a form 1099-C is issued and sent to both the IRS and borrower. This form states who was legally responsible for the debt and what amount was cancelled. In the eyes of the IRS, any amounts cancelled are viewed as income to the taxpayer. In other words, if you were to have $50,000 of debt cancelled, the IRS would see this as $50,000 in income during the year. This can make for a painful tax bill when the cash-flow may not be there to pay it.

There are circumstances that reduce the portion of the debt cancellation that is taxable. Only debt that exceeds insolvency is taxable. What’s insolvency? It’s when your total liabilites exceed your total assets.

You can calulate this by adding up all of your assets at their current fair market value. This would include your house, car, jewlery, clothing, furniture, savings (checking and retirement) etc. Remember, it’s the current fair market value (what you could sell it for) not what you paid for it.

Next, add up all liabilities. This would be mortgages, loans, credit card debt, and the like.

Is the debt portion greater than the asset portion? If yes, you are insolvent. Any debt cancelled up to your insolvency amount (the excess of liabilities over assets) would not be taxable. Any amount that exceeds insolvency is taxable. (There are other rules for insolvency specific to debt cancelled for your primary home, but for the focus of this article on student loan forgiveness, they would not apply).

So, if you are not insolvent or not by much, student loan debt could result in a large tax bill. This is important to keep in mind should anything ultimately be passed by Congress or executive order.