In More Than a Dozen States, Student Loan Forgiveness Tax Can Encounter Issues
The federal government will consider student loan forgiveness tax-free as announced by the Biden Administration. However, it could be taxed at the state level in over a dozen states, which is a minor issue that most states should be able to resolve quickly.
State revenue offices and legislative bodies are juxtaposing their tax laws with President Joe Biden's proposal to forgive up to $20,000 in student loan debt for Pell Grant winners and up to $10,000 for those making $125,000 or less in student loan debt. Typically, paying down debt is seen as taxable income. But according to the American Rescue Plan Act (ARPA), paying down student loans between 2021 and 2025 doesn't constitute federal taxable income.
Is student loan forgiveness taxable? Well, student loan debt cancellation can be taxable depending on how closely a state adheres to the Internal Revenue Code, a term known as "conformity," according to Jared Walczak, vice president of state programs at the Tax Foundation.
“Generally speaking, states use the federal tax code as a baseline for how they define taxability,” said Walczak.
Is debt forgiveness taxable? The answer may be yes in several states, as the following have not complied with all of ARPA's regulations regarding student loan debt: Arkansas, Hawaii, Idaho, Kentucky, Massachusetts, Minnesota, Mississippi, New York, Pennsylvania, South Carolina, Virginia, West Virginia, and Wisconsin. Taxpayers should seek advice from a tax preparer as this is only an interpretation of state discharge of debt regulations.
Depending on the state's tax rate and other factors in its tax code, a tax on debt forgiveness may compel a taxpayer who pays off $10,000 in debt for the 2022 tax year to owe between $500 and $1,100 in state taxes.
Action is Quickly Needed
If the legislatures in the nonconforming states want to exclude their citizens from paying taxes on the cancellation of student loan debt for the 2022 tax year, they will need to act soon. This will be difficult given that the majority of legislatures have ended their sessions for the year. State legislatures would need to enact legislation to explicitly exclude it.
“States could come back very early in the next legislative session, update their conformity statute and make it effective immediately,” Walczak said.
Blue states like Hawaii, Massachusetts, Pennsylvania, and New York will be under further pressure to adhere to federal laws. Early in the following year, lawmakers might still enact measures that would align their tax codes with ARPA for the 2022 tax year. States that have already complied with the law could take action to break away if they disagree with the Biden administration's decision to erase the debt.
Anyone who is unsure about how this impacts them may find it best to consult with a tax professional to be equipped with the right information.
“This is not a niche issue that only affects a few people,” Walczak said. “It affects a very large number of people and hopefully, there will be clarity provided on it.”