Student Loan Forgiveness Leaves State Tax Trap for Borrowers (1)

A provision added to the American Rescue Plan makes forgiven student loan debt not taxable at the federal level, but the tax treatment could differ from state to state.

“It’s a massive patchwork of different approaches to state use of federal income definitions,” said Jared Walczak, vice president of state projects at the Tax Foundation.

President Joe Biden will cancel $10,000 in student loan debt for those earning $125,000 or less and up to $20,000 in debt for Pell Grant recipients, the administration announced Wednesday.

While forgiven loans are typically considered taxable income, a provision in the American Rescue Plan removes tax consequences on student debt that is forgiven until 2026.

• Walczak said while many states conform to the federal definition of taxable income, there are some that don’t. Some states have conformity statutes that are out of date, he said, adding there are a few states that are up to date but expressly exclude the provision.
• “Forgiveness comes at a cost,” Walczak said. “Ultimately, that may be a tax cost. But in the short term, people should just recognize that if their debt is forgiven, that may be a taxable event in their state.”
• The package includes a four-month extension of the moratorium on student loan repayments.
• Biden also plans to propose a rule capping borrowers from paying more than 5% of their monthly income on undergraduate loans. This is a drop from the previous 10% cap.