A little good news: COVID Relief Act includes tax relief for student debtors whose loans are forgiven

 A little good news. The COVID relief bill that Congress passed a few days ago includes modest tax relief for student debtors whose college loans are forgiven.  

Senators Bob Mendez and Elizabeth Warren introduced the Student Loan Tax Relief Act in the U.S. Senate as a provision of the $1.9 trillion COVID relief legislation. 

Thanks to the passage of the Mendez-Warren bill, student debtors who complete income-driven repayment plans (IDRs) and have their college loans forgiven will not get a tax bill.

In most circumstances, the Internal Revenue Service considers a forgiven debt to be taxable income. Until the Mendez-Warren bill became law, this was a problem for student debtors in IDRs.

Indeed, most college-loan debtors in IDRs will have substantial loan balances when they finish making monthly payments under a 25-year IDR because their payments weren't large enough to cover accruing interest.  

The U.S. Department forgives the remaining student-loan debt for individuals who complete IDRs, but the IRS has treated the forgiven debt as taxable income.  Under the terms of the Mendez-Warren bill, that forgiven debt is no longer taxable.

This is a good development, but the Student Loan Tax Relief Act offers is only a modest reform. 

First of all, the IRS does not tax forgiven debt if the debtor is insolvent when the debt is forgiven. Since most student debtors who complete 25-year IDRs will be insolvent, their forgiven debt would not have been taxable even before the Mendez-Warren bill became law.

Second, for reasons I do not understand, the tax-relief measure expires on January 1, 2026.  After that date, forgiven debt will again be treated as income by the IRS.

Third, as the National Consumer Law Center reported earlier this month, only 32 people who completed IDRs have had their loan forgiven. If this low IDR-completion rate continues, the Mendez-Warren measure will impact very few people.

In short, the Mendez-Warren legislation is a welcome development but is no reason for student debtors to start popping the champagne corks. Save the champagne for the day Congress repeals the undue-hardship language in the Bankruptcy Code and allows distressed student debtors to discharge their student loans in bankruptcy.

Don't pop the champagne corks over the Student Loan Tax Relief Act.

Department of Education forgives student-loan debt owed by a wounded veteran, but the IRS sends him a tax bill for $62,000

At age 40, Will Milzarski, an attorney, took leave from his state government job to return to the U.S. Army. After completing officer training, he served two tours of duty in Afghanistan. where he led more than 200 combat missions.

On his last day in combat, Milzarski was wounded in the face, which left him with a traumatic brain injury, hearing loss, and post-traumatic stress disorder.  He was later determined to be totally disabled.

Milzarski returned to civilian life with $223,000 in student-loan debt, most of it acquired to obtain a law degree from Thomas M. Cooley School of Law. In accordance with its policy, the Department of Education forgave all of that debt due to Milzarski's disability status.

But then this wounded veteran received a surprise. The IRS considers forgiven debt to be taxable income, and thus it sent Milzarski a tax bill for $62,000.

Milzarski summarized his experience well. "One part of our government says, 'We recognized your service, we recognize your inability to work," Milzarski said. "The other branch says 'Give us your blood.' Well, the U.S. Army already took a lot of my blood."

Nearly 400,000 disabled Americans have student-loan debt, and this obscure tax provision impacts nearly all of them. Although they are entitled to have their student loans forgiven due to their disability status, this forgiveness comes with a tax bill.

And disabled student-loan debtors are not the only people affected by the IRS forgiven-loans rule. More than 5 million student-loan debtors are in long-term, income-driven repayment plans (IDRs), and most of them are making monthly payments so low that they are not repaying the accumulated interest.

Under the terms of all IDRs (there are several varieties), college borrowers who successfully complete their 20- or 25-year repayment plans are entitled to have any remaining debt forgiven. But IDR participants, like retired Lieutenant Milzarski, will get a tax bill for the forgiven debt.

Obviously, this state of affairs is insane. President Obama recommended a repeal of the IRS rule when he was in office, but nothing  came of his suggestion.

Surely a bill to repeal the IRS forgiven-debt rule would receive bipartisan support in Congress. Who could decently oppose a repeal? In fact, President Trump can probably reverse the rule that is persecuting Mr. Milzarski simply by signing an executive order.

I predict, however, that  that nothing will be done about this problem--either legislatively or by executive action. Washington DC is in so much partisan turmoil that almost nothing positive is getting done. Under current tax law, millions of student borrowers in income-driven repayment plans will have huge tax bills waiting for them when they complete their repayment obligations and have their remaining student-loan debt forgiven.

And unlike retired Lieutenant Milzarski, who is in his forties, most IDR participants will be in their sixties or seventies when their tax bills arrive in the mail. And if they can't pay their taxes, that will not be the government's problem. The IRS will simply garnish their Social Security checks.

Retired Lieutenant Will Milzarski (photo credit Matthew Dae Smith/Lansing State Journal via AP

References

Associated Press. Wounded Michigan vet gets student loan debt forgiven, but now IRS wants $62,000. Chicago Tribune, October 20, 2017.

Jillian Berman. Why Obama is forgiving the student loans of almost 400,000 people. Marketwatch.com, April 13, 2016.

Judith Putnam. Student debt forgiven, but wounded vet gets $62,000 tax bill. USA Today, October 20, 2017.

Michael Stratford. Feds May Forgive Loans of Up to 387,000 Borrowers. Inside Higher Ed, April 13, 2016.

Tax Consequences for Student-Loan Borrowers in Income-Based Repayment Plans: Insanity

The student loan crisis grows worse with each passing day. As the Wall Street Journal noted recently, total student-loan indebtedness is more than five times what it was just 20 years ago, and one out of four borrowers is behind on repayment or in default.

But American universities survive on federal student aid money; they are like addicts waiting on their next fix. Tuition rates continue to go up: Yale announced a tuition hike to nearly $50,000 a year!

The Obama administration knows the student loan program is out of control, but the only thing it can think of to do is roll out income-based repayment plans (IBRPs) that stretch borrowers' payments out for 20 or 25 years.  More than 5 million people are in these plans now, and the Department of Education wants 7 million in them by the end of next year. I think there will be 10 million people in these plans by the end of 2018.

IBRPs reduce borrowers' monthly payments because borrowers' payment terms are based on a percentage of their income--not the amount they borrowed. In Obama's latest two IBRP plans--PAYE and REPAYE--borrowers pay 10 percent of their adjusted gross income for 20 years.

But this is insanity. For most borrowers in PAYE and REPAYE, monthly payments are not large enough to cover accruing interest, and total indebtedness actually grows larger over the years as  accruing interest gets added to the amount that was originally borrowed.

It is true that borrowers who faithfully make loan payments for 20 years will have the remaining loan balance forgiven, but the amount of forgiven debt is considered taxable income by the IRS.  In fact, a Wall Street Journal article advised borrowers to start saving their money to pay the tax bill they will receive when they finish paying off their loans.

Alan Moore, a financial planner who was quoted n the WSJ, made this chilling observation: "If you don't save enough money for the tax bill, all you are accomplishing is swapping your student-loan debt for a debt to the IRS." Moore advised student-loan borrowers to open a segregated account to save for their eventual tax bill and not to invest that money too aggressively due to the risk of a bear market.

Higher Education insiders chant the mantra that people who get college degrees make more money than people who don't go to college. But that is not true for everyone. And that trite observation does not justify forcing millions of people into 20- and 25-year repayment plans that terminate with big tax bills that come due just about the time most Americans hope to retire.

References  

Anne Tergesen. Six Common Mistakes People Make With Their Student Loans. Wall Street Journal, September 12, 2016. Accessible at http://www.wsj.com/articles/six-common-mistakes-people-make-with-their-student-loans-1473645782

Yale Financial Aid Budget Will Meet Term Bill Increase. Yale News, March 9, 2016. Accessible at http://news.yale.edu/2016/03/09/yale-financial-aid-budget-will-meet-term-bill-increase