the Tax bomb on student loans It can happen when you have to pay taxes on the student loan forgiveness you received. However, most people will avoid the tax bomb because of a tax process called… Insolvency.
While some student loan forgiveness programs, like Public Service Loan Forgiveness (PSLF) are always tax-deductible, others — like when you take out your student loans under income-based repayment — will likely be taxable.
However, there is one big exception – Insolvency. Insolvency is a tax situation when your liabilities (such as forgiven student loan debt) exceed your assets (such as the money in your savings account). If you are technically insolvent, you can avoid some or all of the taxes associated with forgiving your loan.
This is a big win for borrowers who get their loans forgiven under IBR, PAYE or ICR. Let’s analyze what that looks like.
Note: Student loan forgiveness expires on December 31, 2025. In 2026, student loan forgiveness will be taxable again.
What is student loan forgiveness?
There are four main areas of student loan forgiveness, each with their own taxes. We’ve talked about student loan and tax relief before, but here’s a quick summary.
1. Federal student loan forgiveness programs These include programs like PSLF, which are tax-exempt student loan forgiveness programs.
2. Student loan repayment assistance programs – These are student loan repayment programs at the state or company level, such as when your employer gives you $5,000 a year toward your student loan debt. These programs are usually tax deductible within certain limits.
3. Student loan cancellation – These are programs that allow your student loans to be cancelled. Some are considered taxable income, others are not. For example, if your student loans are canceled due to school closures, this is considered taxable income. However, if you get your student loans forgiven due to total and permanent disability, that’s tax-free (thanks to President Trump’s student loan programs).
4. Student loan forgiveness due to repayment plan – This occurs when your student loan balance is forgiven at the end of your repayment plan while you are in income-based repayment (such as IBR, PAYE, ICR). This type of student loan forgiveness is considered taxable income and can qualify for insolvency.
What is insolvency?
Insolvency is a technical tax term that means your liabilities (what you owe) exceed your assets (what you have). When it comes to student loan debt, forgiven debt is considered income — which you’ll get a 1099-C for canceled debts. This amount must be reported and there will be taxes due on this “ghost” income. unless The borrower can show that he was insolvent at the time of the forgiveness.
To find out, you must calculateInsolvency amountThis is the difference between your assets and your liabilities. If your insolvency amount is greater than the forgiven debt, you can exclude it and not pay taxes on it. If the insolvency amount is less than the forgiven debt, you may have partial insolvency.
It is important to note that for the purpose of insolvency, the IRS takes into account all the assets you own. This includes basics like your checking account, savings account, and investments, but it also includes things like the values of your retirement account, your real estate, any business property, and even the value of your property.
To figure out liabilities, you need to include any outstanding debts (such as credit card debt, mortgage debt, etc.), as well as the amount of forgiven debt (your student loans).
Example of total insolvency
Let’s look at an example of total insolvency to highlight how this works. This situation could apply to many borrowers dealing with student loan forgiveness, so it’s a good example of what can happen.
This borrower has been on IBR for 25 years, and loans have grown to $70,000. However, he has managed to save a little from his 401k, and has some assets.
Current account – $2000 | Federal Student Loan – $70,000 |
Private Student Loan – $65,000 | |
Credit card debt – $10,000 | |
Total liabilities – $145,000 |
In this example, he has total assets of $60,000 and total liabilities of $145,000. This makes his insolvency figure $85,000. Since his student loan debt was $70,000 – that’s less than the insolvency figure of $85,000 – the total amount of “ghost” income for the student loan debt would not be considered taxable income.
Example of partial insolvency
Let’s look at the example of partial insolvency, which is more common for borrowers. In this scenario, there is more student loan debt, and slightly more assets.
Current account – $2000 | Student loan debt – $170,000 |
Credit card debt – $10,000 | |
Total liabilities – $180,000 |
In this case, the insolvency figure is $100,000. Because the amount of student loan debt ($170,000) is greater than the insolvency figure of $100,000, he must still include the remaining $70,000 as taxable income.
Why most borrowers shouldn’t worry about taxes on their forgiven debt
For most borrowers who get student loan forgiveness, you don’t have to worry about the future tax implications of it. Making payments under an income-driven repayment plan is usually the best-case scenario — if you can afford full payments, you will. You’re on these plans because they’re better than the default alternative.
Secondly, 20-25 years is a long time. There may be major changes in tax legislation before any amount of debt is forgiven and subject to tax.
Finally, the math still works in your favor. Only in extreme cases should large amounts of debt be fully taxable. Most borrowers will see themselves receiving full or partial insolvency, which will significantly reduce any tax burden.
And realize that you are now paying taxes on a much smaller amount of debt. For example, in the case of partial insolvency above, let’s see how this might play out given the current tax brackets. Let’s say this was a single guy or gal, making $45,000 a year. Taxable income of $70,000 would boost your total taxable income to $115,000. This moves him from a 22% tax bracket to a 24% tax bracket.
However, it is ghost income – meaning you have to claim it even though you have no income. This tax liability may be harmful. That brings his total tax bill from $3,770 to $19,010 — a big change of $15,240. This is a lot of money to pay. But look on the big bright side. You just went from owing $170,000 on your student loans to only owing $15,240.
You can run College Investor’s tax calculator to see how much you could owe.
You can easily set up a payment plan with the IRS, make some quick financial changes, and eliminate that debt very quickly.
For small amounts of debt, the math works better.
Final thoughts
As with anything related to tax, the calculations get tricky, every situation is different, and you should really seek the advice of a tax professional when dealing with insolvency. It’s complicated, and has a high potential for audit, so you want to make sure you’re doing everything right. Additionally, you may also have state taxes on your student loan forgiveness as well.
The big lesson here is not to be afraid of the tax consequences of student loan forgiveness programs. Yes, there are tax consequences, but they are manageable and better than any other alternative.
