Student Loan Forgiveness Is Taxable In A Few States, Even If Lenders Do Not Report The Forgiven Amount To The Government
Right now, only six states will impose income tax on the debt forgiveness.
Many people are waiting for the federal government’s student loan forgiveness proposal to take effect. Thankfully, whatever forgiveness amount they receive will not be converted into taxable income on their federal income tax returns where the tax could be as high as 37% of the amount forgiven. But there is concern about state income taxes. So let’s look at which states are currently tax student loan forgiveness and how much the potential tax bill will be.
As of the date of publication, 44 states will not tax the cancellation of student loan debt because they either do not have an income tax, their income tax laws conform with the federal income tax laws, or they have stated that they will pass legislation or other regulations that will exempt student loan cancellation.
Only six states will impose income tax on the debt forgiveness: Arkansas, Indiana, Minnesota, Mississippi, North Carolina, and Wisconsin. This is mostly because these states do not conform with the federal income tax laws. But around the time of President Joe Biden’s announcement, 13 states could have taxed the forgiven income. So it is possible that these states can change their rules in the near future.
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If one of the above states has an insolvency rule similar to federal law, then their student loan forgiveness income could be excluded even if it is taxable. A taxpayer is considered insolvent if their liabilities exceed the value of their assets at the time of forgiveness.
For those who live in one of the states that taxes debt forgiveness, the state tax bill is relatively modest. The average tax rate for these states is around 5%, so those who receive $10,000 in forgiveness will have to pay $500 in taxes and $1,000 for those who get $20,000 forgiven. Minnesota has the highest tax bracket at 9.85% for a single person with over $171,220 in taxable income in 2021. In this case, the state tax bill will be $985 for those who receive $10,000 in forgiveness or $1,970 for those who get $20,000 forgiven.
Given these amounts, in most cases, full-time employees will simply get a smaller state tax refund or a small tax bill. Those who are self-employed, work multiple part-time jobs, or simply do not withhold enough from their paychecks will face a larger than usual tax bill.
But there is a wrinkle. The federal and state governments generally rely on lenders issuing Form 1099Cs on canceled debt to enforce collecting the tax on such income. But the IRS has issued a notice advising student loan servicers and lenders not to issue a Form 1099C on the forgiven debt. The reasoning is that since student loan cancellation is not taxable for 2022, issuing a Form 1099C is unnecessary, would confuse taxpayers, and may force them to pay taxes that they do not legally owe.
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On the other hand, if no Form 1099C is issued, many people would accidentally not report the forgiven amount on their state tax returns. Also, it would be very difficult for states to determine who received loan forgiveness unless they conduct their own investigation.
There may be some who are thinking about not reporting the cancellation of debt income voluntarily to their state. Obviously, they are breaking the law. But if your state somehow finds out about the loan cancellations on their own, they will send a letter to the taxpayer proposing an adjustment to their taxable income. This will then translate into a higher tax bill along with penalties and interest on the unpaid amount. Also, states may not get this information for a very long time which means the adjustment letter may not come for months, if not years. This means that penalties and interest can be substantial.
Only a handful of states will tax those who receive student loan cancellation through the federal government’s proposal. But the tax bill isn’t relatively high, and most people should be able to pay it off eventually. While there is still time for these states to join the tax-free bandwagon, it is a better idea to plan for the worst instead of hoping for the best.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.
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