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How Student Loan Forgiveness Could Shape Your Client’s Tax Plans

Getting clients excited about tax planning may seem like a mountainous task, but COVID-19 relief measures – especially those concerning student loans – have made tax planning nearly impossible to ignore. Three things have changed since last year:

  1. Student loan forgiveness is tax-free until 2026.
  2. All federal student loans are in deferment through September 30, 2021.
  3. All interest rates on federal student loans are zero percent through September 30, 2021.

Now is a good time to talk to your clients about these changes, and Corvee’s tax planning software is an excellent tool to use when evaluating the tax consequences.

Student Loan Forgiveness

Traditionally, student loan forgiveness is taxable. However, in the last few years, tax laws have provided new opportunities for tax-free discharges.

  • The 2017 Tax Cut and Jobs Act (“TCJA”) made student loan discharges due to death and disability nontaxable from 2018 until 2026. 
  • The 2021 American Rescue Plan Act (“ARP Act”) made all student loan forgiveness – of both public and private loans – tax-free from 2021 through 2025.

But these tax measures are only temporary. If your clients’ student loans are forgiven after 2025, they will likely need to report those balances on their returns as cancellation of debt (“COD”) income. COD income is often taxable, but not always. Whether the debt relief is taxable depends on the reason the loan was discharged.

Death or Disability Discharges

Discharges due to death or disability have traditionally been taxable COD income. Though they are temporarily not taxed under both the TCJA and the ARP Act, beginning in 2026, these types of discharges will once again be taxable.

Occupation-Related Discharges

Student loan forgiveness is offered through specific occupation-related programs, including:

These programs have provided taxpayers with rare tax-free forgiveness for decades, and discharges under these programs will continue to be tax-free, even after 2025.

Insolvency and Settlement Discharges

Loan settlements and discharges in the context of a bankruptcy proceeding are excludable COD income regardless of whether the debt is student loan debt or other debt. Such discharges through insolvency and settlements will continue to be tax free even after2025.

Income Dependent Repayment Discharges

Student loan forgiveness was also taxable when borrowers made 20 or 25 years of qualifying payments under income-dependent repayment (“IDR”) plans.  If your clients have their student loans forgiven under IDR programs, those discharges will be tax-free through the year 2025.

Below is a summary of when student loan discharges should be taxed.

Student Loan Forgiveness & Taxation Changes

Forgiveness EventTraditionalNew
Death or 
Disability
TaxableNot Taxable 
(2018-2025)
Public Service or Teacher Forgiveness ProgramsNot TaxableNot Taxable
Bankruptcy and InsolvencyNot Taxable
(With exceptions)
Not Taxable
Income-Driven Repayment FulfillmentTaxableNot Taxable
(2021-2025)

Federal Student Loan Deferment and Zero Percent Interest

The Coronavirus Aid, Relief, and Economic Security (“CARES”) Act passed by the Trump administration in March of 2020 automatically placed all federal loans in forbearance and changed interest rates to zero percent. That relief has been extended several times and lasts through September 30, 2021.

Timeline of Student Loan Covid-19 Forbearance Relief

March 20, 2020Office of Federal Student Aid initiated changes to Education Department owned loans. 
Student loan repayment:  Suspended
Collections of defaulted loans:  Halted
Student loans interest rate set to 0%
March 27, 2020CARES Act enacted the March 20 changes and set an expiration date of September 30, 2020
August 8, 2020Forbearance extended to December 31, 2020
December 4, 2020Forbearance extended to January 31, 2021
January 20, 2021Forbearance extended to September 30, 2021

The government’s student loan relief via the CARES Act is technically a forbearance, which means that interest would continue to accrue. But because the CARES Act lowered interest rates to zero percent, this forbearance has all the benefits of a deferment (during which all activity including interest accrual would cease). No payments will be due, and no interest will accumulate.

If your clients wish, they can effectively opt out of automatic forbearance. If they have the funds to do so, making payments on their loans now, while no interest accumulates, can help them more quickly pay down their principal balance.

Student Loan Tax Considerations

The student loan forbearance will certainly put some cash back in your clients’ pockets, but there is more to think about than just the additional cash flow.

Student loan interest payments – if your clients make any – may be deductible. In 2021, a $2,500 student loan interest deduction is available, subject to phase-outs according to your client’s filing status and modified adjusted gross income (the deduction phases out completely at income of $85,000, or $170,000 for joint filers). If your clients’ loans were placed on automatic forbearance, they may not have much interest to deduct. Not being able to utilize the $2,500 student loan interest deduction could affect your client’s tax plans. With Corvee Tax Planning software, you can assess how a reduction in interest payments will impact their return.

If your clients have COD income from student loan discharges, they will not be taxable through the year 2025. But if your client expects to have student loans forgiven after 2025, you should build that additional COD income into their tax plan. Our tax planning software can help you analyze the impact of nontaxable forgiveness, and you can encourage your clients to start saving for the tax hit now.

Student Loan Tax Relief on the Horizon

Tax-free loan forgiveness under the TCJA and ARP Act is only temporary. It’s possible that lawmakers will make these changes permanent, but right now, the blanket treatment of tax-free student loan discharges is only available through 2025.

Government programs that forgive, discharge, or cancel student loans (like the PSLF program of IDR plans) haven’t changed, and they will continue to be an option in the future. But the Biden administration hopes to offer even more opportunities for loan forgiveness. His administration has discussed canceling $10,000 of student loans for every affected taxpayer, and some members of Congress have considered amounts up to $50,000. A future cancellation of student debt could be taxable, but also could be excluded. The precise effects of any cancellation will depend on who (Congress or the President) cancels the debt and how the cancellation is structured.  

Student loan relief remains fluid and periodically adapts to economic conditions as the pandemic progresses, which makes tax planning increasingly relevant. Tax planning requires knowledge, skill, and planning, and having the right tools to support you and your clients’ decision-making is essential. We update our software regularly to keep pace with the changing tax landscape, you can feel confident that the tools that support you will help you provide the best tax plans for your clients.

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