Student Loans Can Hold Tax Surprises

Due to rising tuition costs, the number and size of student loans have increased dramatically in recent years. Once the exclusive domain of college financial aid offices and hometown banks, education loans are now the subject of cable TV commercials and e-mail solicitations from major credit card companies. Many students run into problems after graduation when loan payments begin. For those students who pursue careers in the high-demand/low-reward public service arena, the repayment problem is especially acute.

Congress has attempted to alleviate this problem by various means, including extending the repayment period for student loans, creating debt forgiveness and debt repayment programs and even providing a tax deduction for the payment of student loan interest. Private-sector employers in high-demand professions have joined in, offering their own student loan repayment plans as a recruitment tool.

As a result, recent graduates face a bewildering array of options for dealing with the substantial debt they have accumulated. Those who successfully negotiate this maze and find a repayment plan or debt forgiveness plan that meets their needs are often surprised by the income tax consequences of their decisions.

FORGIVENESS PROGRAMS AND TAX CONSEQUENCES

Student loan forgiveness plans fall into three categories. The most important are the federal loan forgiveness provisions connected with the extended loan repayment plans elected by qualifying borrowers who are incapable of paying off their education loans over the typical 10-year period. Second, specialized loan forgiveness and loan repayment programs are available for borrowers who work for certain employers (for example, the Peace Corps, the military, and school districts with a high proportion of low-income or special needs students). Third, hardship rules provide debt relief in extreme cases, such as the borrower’s death or disability.

In general, when a lender forgives or discharges a borrower’s debt, the amount of the canceled debt is income that is taxable to the borrower unless it is subject to exclusion under IRC § 108(a). As a consequence, many graduates discover to their chagrin that their student loan forgiveness results in a higher income tax liability. This general rule applies to taxpayers whose student loans are canceled due to hardships, such as death or disability, but not bankruptcy. However, Congress has created two exceptions to this rule: loan forgiveness for public service and payments under the National Health Service Corps loan repayment program. Under the first provision, the unpaid balance of a student loan will be discharged after 10 years if the borrower is employed full-time in a public service job. The second offers loan repayment of up to $35,000 a year for service in the National Health Service Corps.

Today, student loans are ubiquitous, and programs providing for repayment or forgiveness of these loans are becoming more prevalent. Consequently, a growing number of clients will need help from their tax advisers to navigate this complex area.

For a detailed discussion of the issues in this area, see “Student Loan Forgiveness and Repayment Programs: A Roadmap,” by Kent N. Schneider, CPA, J.D., in the June 2009 issue of The Tax Adviser.

—Alistair M. Nevius, editor-in-chief

The Tax Adviser

Also look for articles on the following subjects in the June 2009 issue of The Tax Adviser:

• A discussion of the new section 382 rules after the bailout.
• An analysis of the substantial-authority requirement for undisclosed tax positions.
• A look at state tax amnesty programs.

The Tax Adviser is the AICPA’s monthly journal of tax planning, trends and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price of $85 per year. Tax Section members can subscribe for a discounted price of $30 per year. Call 800-513-3037 or e-mail taxsection@aicpa.org for a subscription to the magazine or to become a member of the Tax Section.