President Announces Student Loan Forgiveness; Potential State Tax Liabilities

By David Neuman, JD 

Last week, the President announced a three-part plan which will significantly impact student loan debt. Further details were subsequently summarized in a Fact Sheet issued by the White House.

The proposal calls for targeted debt relief to be granted by Department of Education (“DOE”) to borrowers through the cancellation of up to $20,000 for Pell Grant recipients and up to $10,000 for non-Pell Grant recipients. To be eligible, the borrower’s income must be less than $125,000 ($250,000 for married couples).

To ensure a smooth transition, the pause in federal student loan repayments will be extended through December 31, 2022. The expectation is that borrowers will be able to sign up for the new debt forgiveness benefit under an application yet to be created by DOE, which will be available before the moratorium on paying student loan debt ends.

Under a provision enacted under the American Rescue Plan Act (“ARPA”), the debt relief may be tax-free for federal income purposes. The ARPA provides that student loan debt cancellation is tax-free from December 31, 2020, through December 31, 2025.

Whether state tax applies to this loan forgiveness depends on whether a particular jurisdiction conforms to this federal law change. The Tax Foundation has reported that, 13 states “have the potential” to tax cancelled student loan debt, though the final number “could be significantly smaller” if states make legislative changes or determine that debt forgiveness can be excluded.

The 13 states cited are Arkansas, Hawaii, Idaho, Kentucky, Massachusetts, Minnesota, Mississippi, New York, Pennsylvania, South Carolina, Virginia, West Virginia and Wisconsin. The maximum likely state income tax liability ranges from $307 in Pennsylvania to $1,100 in Hawaii, with most states in the $500-$700 range.

The Administration’s proposal would also modify the student loan system for current and future borrowers. It proposes a new income-driven repayment plan that caps monthly payments for undergraduate loans at 5% of a borrower’s discretionary income. Currently the threshold is at 10%.

In addition, the definition of “non-discretionary” income will be changed so that a borrower earning less than 225% of the federal poverty level will not be forced to make a monthly payment. The loan balance will not increase due to unpaid interest under this rule.

Certain other program changes are also being considered. The Public Service Loan Forgiveness program will contain a rule under which borrowers who have worked at a nonprofit, in the military, or in federal, state, local, or tribal government will receive a credit toward loan forgiveness.

Additionally, if a borrower has an original loan balance of $12,000 or less, that balance would be forgiven after 10 years (instead of the current 20 years). The Administration estimates that this will allow nearly all community college borrowers to be debt-free within 10 years.

If you have any questions please reach out to your LMC professional.