Student loan forgiveness may be a sweet deal for borrowers, who have collectively accumulated more than $1.3 trillion in debt. The downside: a potentially big tax bill down the road.

The federal government currently offers two types of loan forgiveness for student debt: public service loan forgiveness and loan forgiveness provided by income-based repayment plans, the latter of which requires two decades or more of loan repayment.

The public service route is tax-free while debt canceled by income-based repayment plans is taxed. That potential tax liability could be crippling to lower-income borrowers.

“It replaces student loan debt with tax debt,” said Mark Kantrowitz, publisher of Cappex, a website that connects students with colleges and scholarships.

Tax trouble on the horizon

As currently structured, July 2019 is the earliest any borrower may receive loan forgiveness under an income-based repayment plan and a tax bill from the IRS.

However, unexpected tax bills have already arisen for people who have had their student debt discharged after death or because they are permanently disabled.

In April, a bipartisan group of U.S. senators introduced a bill to eliminate the tax penalty levied on student loans forgiven for death or permanent disability.

“Families grieving the loss or permanent disability of a child did nothing wrong, and they should not be punished by the federal government with a massive tax bill,” Republican Sen. Rob Portman of Ohio said in a statement when he co-sponsored the bill.

“The same tragic reason they cannot pay back their student loans is the reason that they cannot afford an enormous tax increase so contrary to the purposes of our student loan system.”

The taxman doesn’t care if your school closes either. If the 35,000 students enrolled in the recently shuttered ITT Tech schools successfully applied for loan discharges, they may still owe taxes on the amounts canceled.
The number of people affected by tax liabilities from income-based repayment plans will dwarf taxes owed for loan discharges from death, permanent disability and school closures.
The percentage of federal student loan borrowers enrolled in income-based repayment plans has quadrupled over the past four years from 5 percent in 2012 to nearly 20 percent in 2016. Though most borrowers in income-based repayment plans will pay off their debts, low-income workers likely will barely manage to cover the interest on their student loans as their balances grow.

Upon receiving student loan forgiveness, low-income borrowers will owe the IRS up to 25 percent of whatever amount is forgiven plus additional state taxes. Alexander Holt, an education policy analyst at New America, a nonpartisan think tank, used this example:

Take a person who started with $20,000 in debt and had a $20,000 salary in her first year out of college with a 2 percent raise every year. She would have about $44,000 ($30,000 in today’s dollars) forgiven after 20 years. Having never paid more than $10 dollars a month, she would owe the IRS at least $4,000 in today’s dollars in additional taxes that year, which would quadruple her income-tax payment (not including extra state taxes she may owe as well). Overall, that year her federal tax payment would be around 30 percent of her actual, near-poverty-level income.
“A plan that promises borrowers they never will owe a burdensome payment but eventually creates an impossibly large payment out of ‘forgiveness’ is deceptive and has the potential to stop low-income borrowers from enrolling in the program out of fear of the tax,” Holt wrote in his January analysis of student loan forgiveness.

He estimated that the cost of tax-free loan forgiveness for borrowers in income-based repayment plans would be less than $20 million. That sum is tiny compared with the $11 billion the Department of Education spends on income-based repayment plans each year.

The long road

Eligibility for loan forgiveness hinges on the borrower’s ability to make on-time payments. And loan forgiveness programs do not apply to private student loans, which make up about 7.5 percent of the educational lending market.

No borrower will be eligible for the federal public service loan forgiveness until October 2017. The program cancels the remaining balance on your federal student loans after you have made 120 monthly payments while working full time for an approved employer.

In 2012, the Department of Education introduced a voluntary employment certification form to help borrowers track their progress toward meeting the requirements for public service loan forgiveness. Nearly 432,000 people have submitted forms that the department has approved for public service loan forgiveness eligibility.

“One of the biggest questions I’m asked is ‘Am I eligible for public service loan forgiveness?'” said Andy Josuweit, co-founder and CEO of Student Loan Hero, a website that provides free tools to help borrowers manage their debts. In August, the site launched a free calculator to help users determine the benefits of public service loan forgiveness.

If you work in public service, check to see if your state offers a forgiveness program. Often these programs are designed for teachers, social workers, health-care providers and lawyers who work for government agencies or nonprofits. The tax liability of the loan forgiveness depends on the state program.
For those who do not work in public service, loan forgiveness through an income-based repayment plan is an option. Among the four different repayment plans the Department of Education provides, you will need to make 20 years or 25 years of steady payments to be eligible.

Gradible offers a free online student loan evaluation to determine if a repayment plan is right for you.

Borrowers who make it through the gantlet of their repayment plans and still owe on their debts will have their federal student loans forgiven. To satisfy the tax bill, borrowers will have to pay it off in full or enter into a monthly payment plan with the IRS. To start a monthly plan, you will need to fill out Form 9465, Installment Agreement Request.

“The key to such an agreement with the IRS is that you must keep to the terms of the agreement,” said Grafton Willey, a CPA and managing director at accounting and professional services firm CBIZ MHM. “If you default on the agreement, the IRS is not too forgiving.”