Educational debt has been and will continue to be a popular topic of discussion. Having borrowed to attend law school, I’m certainly paying attention. On October 25, President Obama made an announcement proposing some changes to federal student loans. The official White House press release is entitled “Help Americans Manage Student Loan Debt.” Although the proposed changes could affect several million borrowers, millions of financially distressed borrowers are not.
There are two components to the proposed changes: (1) a discount for loan consolidation and (2) accelerating changes to the income-based repayment (IBR) plan. Today I’m going to focus on (2).
The income-based repayment plan allows individuals with federal student loans to make monthly payments equaling 15% of the difference between the individual’s adjusted gross income and 150% of the poverty line for the taxpayer’s family size. If the individual makes timely payments for twenty-five years under IBR, then any outstanding balance remaining, including both principal and interest, is forgiven.
IBR is intended for individuals who don’t earn enough income to pay off their federal student debt under the traditional ten-year payment plan. I won’t highlight every detail about IBR here. For more information, be sure to check out IBRinfo.org.
Obama’s announcement addresses IBR terms. Prior to the announcement, in 2014 IBR payments will be capped at 10% instead of 15% and loans become eligible for cancellation after 20 years instead of 25 years. If Obama’s announcement becomes law, the changes to IBR will take place in 2012.
You would think that the changes impact anyone currently on IBR or who enrolls for IBR in the future. Not even close. In fact, anyone who graduated in 2011 or earlier and does not plan to take out any new federal loans won’t be able to benefit from the changes. To qualify, an individual must have at least one federal loan from no earlier than 2008 and also take out at least one more federal loan in 2012 or later.
Ultimately, the changes only impact some students attending school now or sometime in the future. Recent graduates from undergraduate and graduate programs struggling to make ends meet can’t take advantage.
As it stands, the IBR program does assist financially distressed students with avoiding default on their loans. There’s a tax angle here, however, that makes IBR quite a bit less appealing: Absent applicability of a narrow exception, the loan balance cancelled after twenty-five years is taxable income.
When a taxpayer incurs a debt, there is no taxable event because of the debtor’s promise to repay the principal. And when the debtor fulfills that promise, there is again no taxable event. If the cancellation of the promise to repay the principal does not create taxable income in the amount of the principal (and possibly interest), then taxpayers could avoid receipt of income by always structuring payments as loans followed by cancellation of the indebtedness.
That’s the general idea for having cancellation of indebedness income. One should look more closely at the economics of the transaction to evaluate whether one earned income—or put another way—whether one accumulated wealth as a result of the cancellation.
The U.S. Tax Court has made it clear that in general, cancellation of indebtedness from student loans is taxable income. For students seeking the benefits of IBR, a potentially big tax bill looms after twenty-five years of payments. There are efforts in place to change this result, but one cannot assume it will happen anytime soon.