Newsletters & Articles
The Tax Consequences of Income-Based Repayment of Student Loans
and Marion D. Livermore
This article appeared in the December 2013 edition of the Nassau Lawyer.
This Fall, the Department of Education is launching a new initiative to contact student loan debtors and inform them of various repayment and forgiveness options. One such option is the income-based repayment plan (“IBR”), enacted by Congress in 2007 as a response to unprecedented rates of defaulting student loans. Importantly, the federal government and the mainstream media scarcely mention the personal income tax consequences of IBR, yet these tax consequences may significantly affect a debtor’s decision to use IBR as his or her method of repayment.
IBR is a flexible, affordable payment plan intended to assist student loan debtors in meeting monthly payments. As of July 1, 2009, IBR allows debtors to make monthly payments based on the graduate’s gross income, without regard to the total outstanding balance of the debtor’s loans. Thus, debtors can avoid default using IBR, even during periods of unemployment or substantial underemployment.
Under IBR, debtors are permitted to make monthly payments equivalent to 15% of the difference between the debtor’s adjusted gross income and 150% of the poverty line for the taxpayer’s family size. After twenty-five years of timely payments, any outstanding balance, including interest, is cancelled. There is no requirement that the debtor work in any particular field. Put simply, IBR allows debtors to pay no more than 15% of “discretionary” income toward student loans; after 300 monthly payments, the remaining balance will be forgiven, regardless of whether the debtor works in the public or private sector.
For most debtors, however, the forgiveness of their student loan balances under IBR will come with a significant tax consequence: any amount forgiven under IBR will be taxed to the debtor as ordinary income. The Internal Revenue Code broadly defines gross income as “all income, from whatever source derived.” This definition is followed by a list of specifically enumerated items, including “income from [the] discharge of indebtedness.” In United States v. Kirby Lumber Co.,  the Supreme Court confirmed that cancelled indebtedness must be reported as part of a taxpayer’s gross income because, “by becoming less indebted, the taxpayer has simultaneously become wealthier, and therefore, should be taxed on his or her accession to wealth.” Kirby Lumber still stands to this day as the landmark case regarding cancellation of indebtedness income.
Section 108 of the Internal Revenue Code (“Code”) has specifically provided several exceptions that result in exclusion of cancelled indebtedness from gross income. For example, gross income does not include discharge of indebtedness when the discharge occurs in a title 11 bankruptcy proceeding. Section 108(f) of the Code specifically excludes the income from the discharge of federal student loan indebtedness from gross income, but only when the debtor works for a certain period of time in public service or for the public benefit, which usually entails working for the federal government, a state government, or a 501(c)(3) not-for-profit organization. Notably absent from the list of exceptions is income from student loan debt forgiven under any other circumstances, including forgiveness pursuant to IBR. Thus, cancellation of indebtedness income from the forgiveness of student loans under IBR will be taxed to the debtor as ordinary income, resulting in a sudden and potentially significant personal income tax liability to the extent of the debtor’s marginal income tax rate.
Furthermore, the debtor will not receive a corresponding amount of cash with which to satisfy the resulting tax liability. This cash shortfall is a concept known as “phantom income,” a phenomenon more commonly encountered in corporate and partnership tax law. For debtors with total outstanding balances close to the reported national average of approximately $30,000, the amount of “phantom income” recognized after 25 years should not prove unmanageable, provided the debtors immediately secure adequate employment after graduation and remain employed for the duration of IBR. However, for debtors who experience prolonged periods of unemployment or underemployment, especially those who exit school with large initial loan balances, the total outstanding balance of their student loans may accumulate to an unmanageable level under IBR. In any case, the cancellation of indebtedness income from forgiveness under IBR will prove even more problematic if debtors have not been adequately informed of its existence, thus precluding their ability to prepare accordingly.
Student loan debtors may view IBR as an attractive repayment option for their student loans, but they should consider the tax consequences of opting for IBR before doing so. The concept of forgiveness after 25 years of timely payments may mislead student debtors into believing that they would owe nothing further after their debts are cancelled, especially in light of the government’s omission of in-depth tax information from their IBR resources. The Code, however, provides differently. When considering repayment options, student loan debtors should pay heed to the tax consequences of IBR.
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