Tax Implications of Student Loan Forgiveness

As college tuition prices continue to outpace inflation, students are relying more heavily on student loans to finance their higher education, with the average student graduating with around $30,000 of debt. But there is a silver lining to the debt repayments: The interest paid on these loans can be written off.

You don’t need to itemize deductions to write off the interest, you take the write off as an adjustment to income on Line 33 of Form 1040, thereby reducing your taxable income.

Naturally, there are certain requirements to claim the student loan interest deduction:

1. You cannot claim the deduction if your filing status is married filing separately;
2. No one else can claim you as an exemption on his or her income tax return;
3. You are legally obligated to pay interest on a qualified student loan;
4. You paid the interest on the qualified student loan.

The tax rules get a little more complicated when the circumstances change, like you lose your job and can no longer make payments. After all, things happen over the years that can cause a delinquency or complete inability to repay your student loan.

When this happens, the lender may forgive the loan balance. And if the student loan is charged off, you must include the forgiven balance in taxable income and pay income taxes on it. Of course, if you are bankrupt or can prove insolvency, you may be able to exclude the loan balance from income. But that doesn’t always work.

Earlier this year, the Pay as You Earn Program began to give an estimated additional 5 million borrowers who have owed on student loans for 20 years or more and demonstrated good repayment habits a break on repayment if they are currently underwater. This is debt that will be charged off resulting in potential tax problems for the debtors.

With the total level of outstanding student debt topping $1 trillion, the balances being discharged can be huge, which may result in a tax liability well into the thousands of dollars.

On July 29, Reps. Frederica Wilson, (D-FL), and Mark Pocan, (D-WI), both members of the House Education and Workforce Committee, introduced the Relief for Underwater Student Borrowers Act. This bill would allow student loan borrowers who have been granted debt relief as a result of consistent repayment towards their student loan debt an exemption from being taxed on the amount forgiven.

This is good news for student loan borrowers. If they can’t repay the loans, they likely would be unable to pay off the tax liability generated by the discharge of the debt.

According to a statement by on Wilson’s website, “As a member of the Subcommittee on Higher Education and Workforce Training, college affordability is one of my top priorities. Today, student debt is at a record high, with individual debt forcing many people to put off major purchases such as buying a home or automobile… This bill prevents student loan borrowers from being hit with an additional tax burden for debt that has been forgiven after 20 years of consistent repayment, and in the event of suffering a total permanent disability or death, this bill prevents the debt forgiven from being considered taxable income. The Relief for Underwater Student Borrowers Act helps individual borrowers and their families, as well as strengthens the economy.”

For more information on student loans see IRS Publication 970.