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By Diane Davis
Struggling borrowers who participate in popular student loan repayment plans that offer forgiveness after a period of years potentially face severe tax consequences, a scenario not addressed in the new tax law and one that wouldn’t happen if the debt were wiped out in bankruptcy.
The scope of the problem has yet to come into focus. But the millions participating in so-called income-driven repayment plans, which allow borrowers having a hard time meeting their debt to cap payments at a lower amount and stretch them out over 20 or 25 years before being eligible for loan forgiveness, are the ones who will be on the hook.
The first wave of participants should be reaching the end of their plans in 2019, which means they’ll soon see whether the IRS will be sending out tax bills or whether Congress will step in and authorize a legislative fix.
The income-driven repayment program is “like a ticking time bomb” because the IRS treats the cancellation of debt as taxable income, Judge Michael B. Kaplan of the U.S. Bankruptcy Court for the District of New Jersey told Bloomberg Law.
Borrowers agree to go into these plans when they are fairly young because they want to show good faith and try to repay their debt. Their hope is that when they hit their late 50s and 60s, the debt will be forgiven and they won’t have to deal with it anymore, Kaplan said.
But they are going to be hit with a what could be a big tax bill.
This is just another snag those with significant student debt may have to deal with, although some borrowers participating in these plans may be able to repay their loans in full before forgiveness—and the tax consequences—kick in.
More than 44 million Americans hold more than $1.4 trillion in student debt, most of it from federal sources. With loan availability expanding over the years and outstanding balances growing, the number of borrowers struggling to meet their payments has mushroomed. Of household debt nationally, student loans are second to home mortgages.
More than 8 million borrowers, or about 11 percent of those with loans underwritten by the federal government, are in default, the Education Department estimates.
Politicians, academics, and economists agree that the situation is problematic. Some call it a crisis.
But borrowers don’t have a lot of options to restructure debt, unlike people who find themselves in trouble with credit card, business, or other personal debt.
Bankruptcy is almost never an option for wiping out student loan debt due to the “undue hardship” standard that must be met to qualify, although the Education Department is currently taking another look at its position on that for federal loans. It’s under pressure from Congress and the public to do more to help ease student debt loads.
Student loan borrowers who experience financial hardship and are in default have a right under federal law to remedy their situation by enrolling in an income-driven repayment plan. If a borrower has low or no income, “payments” under the plan can be as low as zero dollars a month.
That may sound like a good deal, but it might not be.
Plus, income-driven repayment plans shouldn’t be part of the analysis when a bankruptcy court is evaluating whether paying back the debt would be an undue hardship, Kaplan said.
Student loan borrowers have been signing up for income-driven repayment plans, such as the Pay As You Earn Repayment Plan (PAYE) and Revised Pay As You Earn Repayment Plan (REPAYE), at a substantial rate.
About 5.3 million people, or a quarter of all borrowers with direct loans, the largest federal student loan program with the government as the lender, were enrolled in IDR plans as of June 2016, compared to 10 percent in 2013, a Government Accountability Office report said in 2016.
The total direct loan volume being repaid annually through IDR plans has increased from $7.1 billion in fiscal year 2011 to $51 billion in fiscal 2015, according to a 2018, Department of Education Office of Inspector General report.
Further increases in students using IDR plans “could result in the federal government and taxpayers lending more money overall than is being repaid by borrowers” in the future, according to the OIG’s report.
The oldest program, the Income-Contingent Repayment Plan (ICR) was created in 1994 and has a 25-year term, “so the soonest anyone with ICR can get loan forgiveness is 2019,” Adam S. Minsky, an attorney specializing in student loan debt in Boston, told Bloomberg Law.
The Income-Based Repayment Plan (IBR) is far more popular but wasn’t in effect until 2008, Minsky said.
The government prefers IDRs over default or over debtors trying to wipe out student loans in bankruptcy. Proposals over the years for Congress to ease restrictions on bankruptcy options for student debt have fallen flat. Although lawmakers did take some action on student debt last year in other areas.
The new tax law enacted in December, the Tax Cuts and Jobs Act of 2017, excludes discharged student loan balances from taxable income due to the death of a borrower, or if they become disabled.
In the case of death, this would help the estate or surviving family of the student who would submit the death certificate, Persis Yu, a staff attorney with the National Consumer Law Center’s (NCLC) Direct Student Loan Borrower’s Assistance Project, told Bloomberg Law.
Federal Parent PLUS loans made directly to a parent can be canceled due to either the death of the student who the loan was taken out for, or for the death of the parent borrower, Yu said.
Also, excluded from taxes are forgiven balances held by someone who becomes disabled.
Loans discharged due to disability are more complicated because a doctor must certify the disability and it is subject to a three-year monitoring period, Yu said.
The tricky part is that the loan isn’t actually discharged for tax purposes until the three-year monitoring period has ended, she said.
About 100,000 borrowers would be affected by these changes based on government data NCLC acquired through the Freedom of Information Act, Yu said. These changes took effect for the 2018 tax year.
A group of people in “unfortunate potential tax situations” will benefit from this tax law change, Greg Rosica, a tax partner with Ernst & Young LLP, Tampa, Fla., told Bloomberg Law. Rosica is a contributing author to the EY Tax Guide 2018.
Elizabeth Maresca, a professor at Fordham Law School in New York, said the new law will have a big impact on people she sees at a low-income tax clinic.
The cases can be dire. For example, the IRS attached a lien to the home of a woman at the clinic who received a disability discharge of her federal student loans due to a chronic illness.
She can’t work and the discharge with a big tax bill “really isn’t helping her,” Maresca said. Borrowers currently in IDR programs who get forgiveness of their student loan debt down the road may be facing a similar situation without congressional action.
President Donald Trump has recently proposed overhauling IDR plans to narrow the number of plan options from four to one, and cap monthly payments at 12.5 percent of discretionary income for new borrowers.
Trump’s proposals would close out loans sooner for millions of borrowers, but also accelerate any tax consequences.
His proposal would eliminate IDR programs like IBR, PAYE, and REPAYE, and implement a new plan with shorter repayment terms like 15 years for undergraduate students, and a longer 30-year term for graduate students, Minsky said in his blog.
Rep. Mark Pocan (D-WI), Rep. Rick Nolan (D-MN), and Rep. Frederica Wilson (D-FL) proposed the “Relief for Underwater Student Borrowers Act” in 2016. It would’ve allowed borrowers who’ve been granted debt relief as a result of consistent repayment an exemption from taxes on forgiven amounts.
Congress has to weigh in and “nothing looks likely in the near term,” Minsky said.
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