Will I face a 'tax bomb' on student loan forgiveness?

People who benefit from student loan forgiveness may be wondering about the tax consequences of this debt relief option, including a potential "student loan tax bomb." 

There are several situations that can lead to a borrower facing this situation, and some ways to prevent it.

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Here’s what to know if you received student loan forgiveness or could in the future.

What is a student loan "tax bomb?"

A "tax bomb," or in this case a "student loan tax bomb," occurs when a forgiven debt becomes taxable income – meaning the borrower has to pay taxes on that amount.

The IRS generally taxes all income sources, including when a creditor cancels, forgives or discharges a debt. 

The amount forgiven is typically included in the individual's gross income and is subject to income taxes, unless a tax law specifically excludes it from taxable income, according to TurboTax

The student loan lender will report a forgiven balance on Form 1099-C, Cancellation of Debt.

If my student loans were forgiven, will I be ‘tax bombed?’

A federal student loan balance being forgiven, and a resulting tax bomb, primarily impacts borrowers who use an income-driven repayment plan, according to TurboTax. 

These payment plans typically last for 20 to 25 years, and require the borrower to pay between 10% to 20% of their discretionary income. Any remaining balance after the payment plan ends is forgiven. 

This forgiven amount of money can be considered taxable income in the year it occurs, TurboTax says – depending on the borrower’s repayment plan and loan program.

But there is a significant update on this through the end of 2025: Borrowers who are eligible for student loan forgiveness will not be taxed on that amount through the end of 2025, thanks to a provision in the 2021 American Rescue Plan.

After 2025, however, the forgiven student loans may again be subject to federal income tax unless further legislative measures are adopted to extend or replace the current exemption, according to Carlos Samaniego, an Enrolled Agent (EA) and founder of Tax Debt Consultants, LLC. 

Lastly, borrowers should consider their state-level taxation implications of forgiven student loans. 

"Despite the federal exemption, some states may treat forgiven student loan debt as taxable income, with policies varying significantly across the country," Samaniego told FOX Television Stations. 

"Borrowers should stay informed about their state's stance on this issue to fully understand the potential tax implications of loan forgiveness," he added.

Are there certain situations that could cause a ‘tax bomb?’

FILE - A student takes his final exam in a lecture hall at the University of Texas at Austin on Feb. 22, 2024 in Austin, Texas. (Photo by Brandon Bell/Getty Images)

FILE - A student takes his final exam in a lecture hall at the University of Texas at Austin on Feb. 22, 2024 in Austin, Texas. (Photo by Brandon Bell/Getty Images)

Yes, there are several situations that could lead to a "tax bomb," according to Samaniego. Here are some common scenarios:

  1. Income-Driven Repayment Plan Forgiveness: For those on income-driven repayment plans for federal student loans, any remaining balance forgiven at the end of the repayment period – usually after 20 or 25 years – is considered taxable income by the IRS, unless current laws change.
  2. Private Loan Settlement: If a borrower settles a debt with a private lender for less than the amount owed, the forgiven portion can be considered taxable income. This is common with credit card debt negotiations, personal loans, and private student loans, Samaniego told FOX Television Stations.
  3. Mortgage Forgiveness Debt Relief: In cases where a lender forgives some of a mortgage debt — such as after a foreclosure or a short sale — the forgiven amount could be taxable, according to Samaniego. There have been temporary exceptions, like the Mortgage Forgiveness Debt Relief Act, but these are subject to change and expiration.
  4. Business Debt Forgiveness: If a business owner’s debt is forgiven, that amount might become taxable income. This could happen in various forms, such as a creditor forgiving a portion of the loan or through restructuring of business debts.
  5. Changes in Federal or State Legislation: Tax laws can change, affecting how forgiven debts are treated. "For instance, if laws like the American Rescue Plan are not extended or replaced, scenarios that currently avoid a tax bomb could potentially lead to one in the future," Samaniego said.

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How to prevent a student loan forgiveness ‘tax bomb’

Preventing a student loan forgiveness "tax bomb" from impacting a borrower financially requires planning and understanding the tax implications of debt forgiveness, according to Samaniego.

He recommends saving for the potential tax bill down the line. 

"If you anticipate debt forgiveness in the future, such as through an Income-Driven Repayment (IDR) plan for student loans, start saving now for the potential tax liability," he told FOX Television Stations. "Setting aside a small amount regularly can help manage the tax impact when the forgiveness period ends."

Other strategies include researching tax-exempt forgiveness programs, paying attention to tax laws and policies moving through Congress, and even negotiating with creditors. 

"If dealing with private debt, negotiate with creditors not only on the terms of debt forgiveness but also on how the forgiveness is reported," Samaniego said. "Sometimes, creditors may be willing to report the debt differently to minimize tax implications." 

Another option could be considering an insolvency claim. If liabilities exceed assets at the time the debt is forgiven, the borrower may not have to pay taxes on the forgiven amount, he said. 

Lastly, borrowers should consult a tax professional to get personalized advice and plan accordingly. 

"Preventing a tax bomb involves early planning, saving, and staying informed about tax laws and your options. Each situation is unique, so tailored advice from a tax professional is invaluable," Samaniego said.

This story was reported from Cincinnati.