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Sunday, August 28, 2022

Taxation of Forgiven Student Loans and Some Observations

student in graduation gown with weight labeled debt attached to his foot

President Biden's announcement on August 24 that many individuals with student loan debt would see up to either $20,000 (Pell Grant recipients) or $10,000 (others) forgiven has unsurprisingly received a lot of attention. To qualify, borrowers must have income under $250,000 if MFJ or HH or under $125,000 for all others.  The announcement did not say what this measure of income is (AGI, modified AGI, something else) and for what year. The White House estimates that this income level is about 95% of individuals.

First - what is the tax effect? The American Rescue Plan Act (P.L. 117-58, 3/11/21) modified Code §108(f) to provide that for 2021 through 2025, gross income excludes income from cancellation of higher education student loans. So, for federal purposes, assuming these cancellations of up to $20K or $10K of student loans occurs in 2022 through 2025, no federal income tax is owed.

I have seen a few articles and news reports that some states might tax this income, making it sound like a dreadful result. Certainly, tax-free is better than taxable, but the borrower is still in a better position than paying that principal and interest on their own. For example, if someone with a state income tax rate of 5% has $10,000 of student loan cancellation income and is in a state that taxes that $10,000, they are out of pocket $500.  That's much better than out of pocket $10,000 of principal and the interest on it.

For additional information on this announcement, see:

Next - The significant and growing amount of student debt is a problem. There is no specific plan to address the numerous issues leading to so much student debt in these announcements.  There are a few items noted such as the Department of Education publishing lists of "programs with the worst debt levels in the country," and "requesting institutional improvement plans from the worst actors that outline how the college with the most concerning debt outcomes intend to bring down debt levels" (see the end of the White House Fact Sheet). This won't go far enough.

Per the Federal Reserve Bank of New York, at the 2nd quarter of 2022, individuals held the following aggregate debt amounts:
  • Mortgages - $11.39 trillion
  • Home equity debt - $320 billion
  • Credit card balances - $890 billion
  • Auto loan balances - $1.5 trillion
  • Student loan balances - $1.59 trillion
  • Other - $470 billion
  • TOTAL - $16.15 trillion

That is a lot of debt! 

A few observations and questions:

  • Why don't we see this large group of borrowers ask Congress why they can't deduct interest annually on up to $750,000 of debt regardless of the debt?  Or stated otherwise, why is the mortgage debt limit so high (far higher than the median home price in the U.S.) and other type of debt is not favored (there is an income-limited and deduction-limited above-the-line deduction for student debt interest).  Caveat: I don't think the mortgage limit should be so large as it is out of lime with what 95% of individuals could qualify for and is an "upside-down" tax subsidy.
  • Why no caveats on the debt forgiveness other than the income limit? Why not add a rule along the lines of - if your university was charging tuition above the national average for a state university, it must cover $5,000 of the debt and the government will match the other $5,000 (of $10K for a Pell Grant recipient)? Tuition at many universities is way too high! You can find examples of over $100,000 for an MBA degree.  btw - an MST at San Jose State is $20,000 and this is a high quality program (imho).
  • What about financial literacy in high school to help students understand the costs of all types of borrowing and how high debt can affect your future spending needs such as buying a home and raising a family.
  • What about finding ways to reduce tuition costs and have universities charging tuition above some specified level to have to handle the lending (and risks) on their own?
  • The student loan problem is an awful one caused by the government, universities, lenders and borrowers who may not have had all of the facts or not had the financial literacy education or experience to see the problems of high student loans. If you want to get better insight into all of the problems, I encourage you to read The Debt Trap: How Student Loans Became a National Catastrophe, by WSJ reporter Josh Mitchell.  It changed my view on this to be lean more towards forgiving some of this debt and perhaps all of it for individuals with lower income than what Biden's current plan calls for.  Prior to reading this book, I didn't know the history of how the lending program was started years ago and the perverse incentives that exist to really take advantage of parents and students.  It is awful.  
  • Pell Grants should be increased and the money can be found by reducing tax breaks for individuals with income high enough to not need them. Also, more is needed to get more universities to use any large endowments they have (subsidized by all of us via the tax law) to use them to provide opportunities for all who qualify to get a degree.
btw - my 10 years of schooling and three degrees including two from private universities was self-funded while I worked full time. I survived but this isn't for everyone. My first degree from CSU Northridge cost me $100/semester for tuition/fees (books were far more)!  Why does it cost so much more today - about $4,000 per semester at SJSU (although still a bargain in California compared to many other states). Inflation adjusted, $100 in 1980 would be $380 today. This likely isn't a good comparison though because it should have cost more than $100 in 1980 but back then, the state (taxpayers) paid for far more of the costs and I think costs at universities were much lower in 1980 compared to today. But still, how did the cost go up so much more than inflation?

What do you think (about the tax aspects or solutions to avoid debt cancellations in the future)?

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