Senate Passes Proposal for Tax-Free Student Loan Forgiveness

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Mark Kantrowitz

By Mark Kantrowitz

March 11, 2021

UPDATE: On March 11, 2021, President Biden signed the American Rescue Plan Act of 2021 into law.

The $1.9 trillion Covid-19 relief legislation passed by the U.S. Senate makes all student loan forgiveness tax-free.

The American Rescue Plan Act of 2021 passed in the Senate on March 6, 2021 by a vote of 50 to 49 along party lines. It now returns to the U.S. House of Representatives, where it is expected to pass.

The 628-page legislation excludes from income all federal and private student loan discharges.

Normally, the cancellation of debt is treated like income to the borrower. It’s as if someone gave the borrower money to pay off the debt. The borrower received an IRS Form 1099-C to report the cancelled debt as income. The cancelled debt is subject to income taxes just like any other income.

Certain types of student loan forgiveness are already tax-free. This includes

  • Public Service Loan Forgiveness
  • Teacher Loan Forgiveness
  • Loan forgiveness programs for nurses, doctors and veterinarians
  • Loan forgiveness programs for public interest law
  • Death and disability discharges
  • Closed school discharges
  • False certification discharges (e.g., identify theft)
  • Unpaid refund discharges

However, the cancellation of the remaining student loan debt after 20 or 25 years in an income-driven repayment plan was taxable under previous law. The new legislation will make this loan forgiveness tax-free.

This will mostly affect borrowers who are repaying their student loans under the Income-Contingent Repayment (ICR) plan. The first borrowers under ICR are now reaching their 25th year in repayment. These borrowers may be able to switch into the Revised Pay-As-You-Earn Repayment plan (REPAYE) to qualify for 20-year loan forgiveness, counting the years in ICR toward the 20-year requirement.

Borrowers in other income-driven repayment plans will not reach the forgiveness mark until after the 2025 expiration of the tax-free status. For example, Income-Based Repayment (IBR) first became available on July 1, 2009. Even assuming they had three years of an economic hardship deferment before this date and switch into REPAYE to qualify for 20-year forgiveness, the soonest they could qualify for forgiveness of the remaining loan balance is 2026.

However, it seems likely that the expiration date will be extended and maybe even made permanent. Federal budgets are typically passed in 5-year increments, forcing an extension every one or five years until Congress decides to make a provision permanent.

Borrowers are excited by this development because they believe that it foreshadows future blanket student loan forgiveness. President Biden has said that he supports $10,000 in student loan forgiveness per borrower. Senators Schumer and Warren have been calling for $50,000 in student loan forgiveness per borrower. This loan forgiveness will be tax-free under the just enacted exclusion from income for full or partial student loan forgiveness.

The text of the legislation is as follows:

(a) IN GENERAL. — Section 108(f) of the Internal Revenue Code of 1986 is amended by striking paragraph (5) and inserting the following:
‘‘(5) SPECIAL RULE FOR DISCHARGES IN 2021 THROUGH 2025.—Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) after December 31, 2020, and before January 1, 2026, of —
‘‘(A) any loan provided expressly for postsecondary educational expenses, regardless of whether provided through the educational institution or directly to the borrower, if such loan was made, insured, or guaranteed by —
‘‘(i) the United States, or an instrumentality or agency thereof,
‘‘(ii) a State, territory, or possession of the United States, or the District of Columbia, or any political subdivision thereof, or
‘‘(iii) an eligible educational institution (as defined in section 25A),
‘‘(B) any private education loan (as defined in section 140(a)(7) of the Truth in Lending Act),
‘‘(C) any loan made by any educational organization described in section 170(b)(1)(A)(ii) if such loan is made —
‘‘(i) pursuant to an agreement with any entity described in subparagraph (A) or any private education lender (as defined in section 140(a) of the Truth in Lending Act) under which the funds from which the loan was made were provided to such educational organization, or
‘‘(ii) pursuant to a program of such educational organization which is designed to encourage its students to serve in occupations with unmet needs or in areas with unmet needs and under which the services provided by the students (or former students) are for or under the direction of a governmental unit or an organization described in section 501(c)(3) and exempt from tax under section 501(a), or
‘‘(D) any loan made by an educational organization described in section 170(b)(1)(A)(ii) or by an organization exempt from tax under section 501(a) to refinance a loan to an individual to assist the individual in attending any such educational organization but only if the refinancing loan is pursuant to a program of the refinancing organization which is designed as described in subparagraph (C)(ii).
The preceding sentence shall not apply to the discharge of a loan made by an organization described in subparagraph (C) or made by a private education lender (as defined in section 140(a)(7) of the Truth in Lending Act) if the discharge is on account of services performed for either such organization or for such private education lender.’’.
(b) EFFECTIVE DATE. — The amendment made by this section shall apply to discharges of loans after December 31, 2020.

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