What is the federal student-loan forgiveness policy just announced by President Joe Biden, and what effect does that have on a borrower’s taxes?

The Department of Education will provide up to $20,000 in debt cancellation to Pell Grant recipients with loans held by the Department of Education, and up to $10,000 in debt cancellation to non-Pell Grant recipients. Borrowers are eligible if their individual annual income is less than $125,000 ($250,000 for married couples). Pell Grants are those based on financial need of the student.

While the relief could be automatic for borrowers whose income information is readily available to the department — either through a FAFSA form or income-driven repayment plans — the majority of borrowers will have to apply through an online form. Forms will become available in early October and applicants have until Dec. 31 to file.

The pause on federal student loan repayment will be extended one final time through Dec. 31. Payments will resume Jan. 1.

Borrowers who still owe money after forgiveness will have lower payments. Payments will be capped at 5 percent of discretionary income, a reduction from the current 10 percent. Loan balances that originated at or below $12,000 will be forgiven after 10 years of on-time payments, a reduction from the current 20-year plan.

Individuals who have been making loan payments voluntarily since March 2020, when federal payments were paused, can request a refund for those payments. Those individuals must contact their loan servicer to request the refund.

What tax impact will a waiver of their debt have on borrowers?

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Generally, under IRS regulations, a waiver of a debt made by a qualified lending institution is considered taxable income. That means that the amount waived is considered income. That will cause a borrower to be taxed at the rate applicable for that income, or possibly raise the borrow to a higher tax bracket because of added reported income.

Under federal tax law, this student debt waiver will not be considered taxable income. The American Rescue Plan Act of 2021 exempts student loan forgiveness from federal income tax returns through the end of 2025.

Most states with income tax have their tax codes linked to whatever the IRS regulations are for defining taxable income. Illinois is one of those. Accordingly, those student-loan borrowers (or guarantors like mom and dad) who are subject to Illinois taxes, will not have the amount of the forgiven debt treated as income for purposes of Land of Lincoln taxes.

However, some states have their own tax provisions for debt waiver by lenders which are not tied to federal law. And those states would not be bound by the federal regulation.

If a borrower is subject to those states’ income tax (Minnesota, Arkansas, Mississippi, North Carolina and Wisconsin, for example), the borrower may be subject to the waiver-income rule of those states. What tax year is applicable depends on exactly when the Department reports a waiver for a particular borrower.

The student loan waiver may not only be an early Christmas gift to borrowers, but a Christmas carol for the Democratic party in the upcoming midterm elections in November.

For fiscal conservatives, it’s another burdensome link in the national debt-chain dragged by Marley’s ghost.

Brett Kepley is a lawyer with Land of Lincoln Legal Aid Inc. Send questions to The Law Q&A, 302 N. First St., Champaign, IL 61820.

Brett Kepley is a lawyer with Land of Lincoln Legal Aid Inc. Send questions to The Law Q&A, 302 N. First St., Champaign, IL 61820.

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