Bloomberg Tax
March 28, 2023, 8:45 AM

Student Loan Paradigm Shift Is Changing the Game for Tax Pros

Zack Geist
Zack Geist
Student Loan Tutor

Recent updates to the federal student loan program will allow some borrowers to count backdated payments toward their loan forgiveness date, and the Biden administration is waiving federal taxes on loans forgiven through 2025. Biden is also attempting a $10,000 loan forgiveness for all borrowers who qualify but is getting pushback from the Supreme Court, as there are doubts about its constitutionality.

The tax waiver news applies to more than 43 million Americans with federal student loans. But many don’t know how to take advantage of the new rules, nor how they’ll be affected when debt forgiveness.

More than 8.5 million borrowers are enrolled in an income-driven repayment plan that caps the amount they pay as a percentage of their discretionary income. In IDR plans, borrowers must update their income annually or whenever it changes. Borrowers also may have their loans forgiven after 20 or 25 years (equal to 240 or 300 monthly payments). The goal is to make loan repayment more affordable for borrowers struggling to make timely payments under a standard plan.

The American Rescue Plan Act includes two significant provisions affecting student loans. The first is a waiver that allows borrowers to have all previous payments, regardless of loan type or repayment type, count toward forgiveness. Backdated payments may now include any months’ deferment prior to 2013 and any months of payments before consolidation of federal student loans.

The waiver expires on May 1, 2023, so borrowers who want to take advantage of this provision must consolidate their loans in the Department of Education’s Direct Loans Program before the deadline if they want to receive the onetime backdating of qualifying payments. Some who consolidate their loans on time will find they are much closer to their loan forgiveness date than they realized.

The second significant update is a federal tax exemption for all student debt canceled through 2025. Typically, the canceled debt is treated as gross income and susceptible to taxes. If a borrower has their debt canceled before Jan. 1, 2026, the canceled debt won’t be taxed. The exemption doesn’t apply to state taxes owed in Minnesota, Arkansas, Indiana, Mississippi, North Carolina, and Wisconsin.

The IDR Revised Pay as You Earn plan, which launched in 2014, forgives 50% of the negative interest accrued annually, which is a major benefit for borrowers. This summer, REPAYE is being adjusted to 225% of discretionary income, which means borrowers can earn more before a payment is due.

Couples will have the option to file taxes as married filing separately with REPAYE, and negative amortization forgiveness will be increased to 100%, making federal student loans interest-free—even with $0 payments. Borrowers who can sustain $0 payments over their loan’s life will pay taxes on the forgiven student debt based on the original loan amount, which means they could pay a maximum of 37 cents on the dollar for every dollar they borrowed 20 to 25 years prior.

Let’s compare different tax scenarios for Mary and Jay, a hypothetical married couple with student debt. The first two examples focus on their savings based on varying income levels, while the third focuses on a tax event triggered by loan forgiveness.

Example One

Let’s say Mary has $180,000 in federal student loans at a 6.25% interest rate and earns $85,000, while Jay has no student loans and earns $75,000. Under the REPAYE plan, filing separately would save the borrowers $155,847 overall and $527.62 in cash-flow over 25 years compared to filing jointly. This showcases the potential advantages of filing taxes separately for taxpayers with federal student loans.

Example Two

Now, let’s say Mary has a $105,000 salary and $180,000 in federal student loans, while Jay has a $55,000 salary and no student loans. Under the REPAYE plan, filing separately would save the borrowers $105,846 overall and $361.95 in cash flow over 25 years compared to filing jointly.

Example Three

Finally, let’s say Mary and Jay have $100,000 in federal student loan debt and three children, and both make $67,500 a year. By filing taxes separately and using the REPAYE plan, their monthly payments would be $0 because of their family size. The proposed 100% negative amortization forgiveness would make their loans interest-free. After 20 to 25 years, the remaining balance would be forgiven and taxed as gross income, resulting in a $100,000 tax event. Regarding overall tax paid on income, filing separately would result in higher taxes, but the savings from the loan forgiveness could outweigh the tax liability.

The latest revisions to IDR plans could mean more borrowers qualify for loan forgiveness sooner—but they must be prepared to pay the taxes.

Let’s say a borrower consolidates their loans before the May 1 deadline and suddenly, due to having so many months of newly qualified payments under their belt, finds the loans will be forgiven on March 1, 2026. The forgiven amount will be treated as gross income and taxed accordingly.

On top of all of this, there are banks offering lower interest rates, and many student loan advocacy groups are either losing money or have gone out of business entirely. This is after the eight consecutive forbearance extensions. SoFi Bank is an example of a student loan giant that has been massively impacted as revealed by their recent lawsuit.

As the landscape continues to evolve, borrowers should employ a tax adviser to help them prepare for the large tax implications of treating canceled debt as income. Advisers should ask if their clients have federal student loans before they begin tax preparation or planning, as this can drastically alter their clients’ filing needs.

Ultimately, borrowers with more than $75,000 of student loans would benefit tremendously from a consultation with a student loan professional. An adviser with a background in this unique type of loan can identify all options available for IDR plans and provide other financial advice.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Zack Geist is the founder of Student Loan Tutor, a student loan repayment management and solutions firm that develops and executes custom repayment strategies for borrowers and offers conscious wealth management services. Geist is also the founder of Holistic Finance, the parent company of Student Loan Tutor.

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