TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Tuesday, June 26, 2018

WSJ: Student-Debt Forgiveness Is A Wonderful Boon, Until The IRS Comes Calling

WSJWall Street Journal, Student-Debt Forgiveness Is a Wonderful Boon, Until the IRS Comes Calling:

Students seeking relief on their college and graduate-school debt could be sitting on a hidden tax bomb: Billions of dollars in one-time bills from the Internal Revenue Service for any debt they get forgiven.

The tax bills are a feature of the “income-driven repayment plans” that have been offered by the Education Department since 2007. One version of these plans allows borrowers to set their monthly student-loan payments at 10% of their discretionary income. The balances often grow over time because the payments aren’t big enough to cover accruing interest.

Private-sector workers pay for 20 or 25 years. At the end of that period, any remaining balance would be forgiven. Under federal tax rules, that disappearing debt is considered part of a borrower’s income for that given year, and taxed as such.

Those delayed tax bills are piling up. There are now 7 million borrowers owing $389 billion in income-driven repayment, according to the Education Department. The first borrowers likely won’t have debt expunged until 2027. As enrollment surges, education analysts and student advocates are warning of a potential crisis facing borrowers and the government down the road: huge one-time tax bills that individuals aren’t prepared to pay off.

With the inflating tax bills, the plans for some borrowers resemble “balloon payment” plans offered by some mortgage lenders, under which borrowers make low monthly payments for a period and then are required to make a big, one-time payment to pay off the sum. Some policy makers have criticized balloon payments as a form of risky lending.

“I’m very doubtful that everybody is going to be able to make these tax payments,” said Constantine Yannelis, an assistant professor of finance at New York University who worked in the Obama Treasury Department. “And I’m also doubtful that policy makers and society as a whole are going to be OK with jailing people for tax evasion because their student-loan balances are being forgiven.”

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Rising college debt, encouraged by government and universities, did what medical costs did with medical insurance and government guarantees -- it made more money available, took away incentives for universities to constrain costs, and did not discourage unwitting students from borrowing their future lives away for majors that wouldn't provide a means for repayment. It created a false impression that college was worth the ever-increasing costs, despite money being directed less for education and more for administration. It's time to pull back before the crisis gets worse and taxpayers have to bail out "universities too big to fail."

Posted by: Woody | Jun 26, 2018 3:01:35 PM

Anyone facing the possibility of recognizing income from discharge of student loan debt should keep in mind that IRC Sec. 108(a)(1)(B) allows such income to be excluded to the extent the taxpayer is insolvent. It is not hard to imagine that people with a huge student loan obligation, along with other debt, could likely be insolvent, and the debt forgiveness income would not be taxable to the extent of their insolvency. And the insolvency computation includes the student loan debt.

Posted by: Robert J. Nagy, CPA | Jun 27, 2018 9:36:52 AM

And to think it was only one day shy of a month ago we saw this: Says Georgetown Law professor John Brooks: "If a borrower promises only to pay a percentage of income, the nominal amount of the debt is not as crucial."

Except for the giant tax hit / balloon payment that they won't be able to afford. As I calculated in the comments at the link above, for someone paying sticker at Brooks's GULC, as 44% of the students there do, that tax hit / balloon payment may well add $125k to their tax bill the year their loans are forgiven - this amount is more than it would have cost them to buy a GULC degree at sticker a decade ago!

Posted by: Unemployed Northeastern | Jun 27, 2018 9:44:02 AM

@ Robert J Nagy,

So it really is free money so long as you are guaranteed to be insolvent at the age of 50. What a deal!

Posted by: JM | Jun 27, 2018 10:11:13 AM

@Robert Nagy,

A solid notion, but it doesn't make for the best law school sales pitch: apply now, declare insolvency in 20+ years!

Posted by: Unemployed Northeastern | Jun 27, 2018 10:47:52 AM