Student Loan Forgiveness and Insolvency: What You Need to Know

We get asked all the time about student loan forgiveness during the Biden administration. What do we think? Will Biden forgive all student loans or just $50,000? Understandably, borrowers don’t want to miss out on that.

Short answer: we still don’t know, but we doubt it.

However, if you’re fortunate enough to have had some or all of your student loans forgiven after paying for 20 or 25 years on an income-driven repayment plan, you’ll need to familiarize yourself with the term, “insolvency.” Insolvency can potentially allow you to avoid some or all of the taxes associated with your loan forgiveness.

The IRS insolvency rule

Insolvency is a tax situation where your liabilities exceed your assets.  For example, this could happen when your student loan forgiveness (liability) exceeds the money in your savings account (asset).  Keep reading for examples of the insolvency rule in action.

Federal income taxes on student loan forgiveness

In March 2021, Congress passed the American Rescue Plan Act which made federal, private, and institutional student loan forgiveness tax-free, through 2025. Beforehand, only loans forgiven through the Public Service Loan Forgiveness (PSLF), Teacher Loan Forgiveness and the National Health Service Corps Loan Repayment Program were exempt from taxation.

When student loans are forgiven, you’re issued a Form 1099-C. This form shows the amount of forgiven debt to be included as income. Taxes are due on this income unless you can show that you were insolvent at the time of forgiveness.

Am I insolvent?

Insolvency is a technical term used by the IRS. A taxpayer is insolvent when their total liabilities exceed their total assets. If you’re insolvent immediately before your loans are forgiven, you might be able to avoid some or all of the taxes associated with your loan forgiveness.

When determining insolvency, the IRS considers all of the assets that you own. This includes:

• Checking and savings accounts
• Retirement accounts
• Your possessions
• Real estate
• Investments
• Business ownerships

To calculate your liabilities, include any debt owed including credit cards, car loans, mortgage debt, etc. in addition to your student loan debt.

Let’s run through some insolvency examples.

IRS insolvency rule: tax-free forgiveness

Clay has $3,000 in his bank account, $10,000 in 401(k) savings and a motorcycle worth $4,000. All of these are considered assets. Altogether, Clay has $17,000 in assets. In total, Clay has $48,000 in liabilities, which includes $15,000 in outstanding credit card debt, a $3,000 auto loan and $30,000 in student debt.

To calculate his net worth, subtract the $48,000 of liabilities from the $17,000 in assets. In this scenario, Clay has a negative net worth of $31,000.

If his student loans of $30,000 are forgiven, he’s still insolvent with a negative net worth of $1,000. Due to Clay’s insolvency before and after the student loan forgiveness, he wouldn’t owe any taxes on his student loan forgiveness.

Partial insolvency: you owe some tax on student loan forgiveness

Becky has a total of $30,000 in assets. She has $50,000 in liabilities which includes $40,000 of student debt. Therefore, Becky has a negative net worth of $20,000 and is considered insolvent.

However, after her student loans are forgiven, her net worth changes from a negative $20,000 to a positive $10,000. The income on the starting insolvent position isn’t taxable, but the remaining $10,000 is taxable.

Full tax-bomb payment

Jennifer has $100,000 in assets. She has $60,000 in liabilities, which includes $20,000 in student debt. Before her student loans are forgiven, she has a net worth of $40,000.

After her student loans are forgiven, she still has a positive net worth. Because Jennifer was solvent prior to, and after, her student loan debt forgiveness, the entire student loan forgiveness is taxable.

Who is the insolvency rule best for?

As you can see from the examples above, everyone has a different tax situation. When dealing with student loan forgiveness, you could face a potentially large tax bill from your state or from the federal government after 2025.

The insolvency rule is ideal for borrowers who can’t save for the tax bomb or borrowers who move abroad and don’t intend to return to the U.S.

Insolvency can have a dramatic effect on your taxability on your student loan forgiveness.  It’s complex and requires the help of a tax professional. Although it might seem like a lot of money to work with a tax professional, it might potentially save you thousands in taxes on your student loan forgiveness.

A reminder about taxes and different loan forgiveness types

Not all loan forgiveness programs are alike when it comes to taxes. Some student loan forgiveness programs, including PSLF, allow for tax-free student loan forgiveness. Other forgiveness programs can result in a tax bill on the loan amount that’s forgiven.

If your student loans will be forgiven under an income-driven repayment program, like Pay As You Earn (PAYE), you could face a future tax bill.

Each type of loan forgiveness option has its own pros and cons, requirements, and taxability.

1. Federal tax-free student loan forgiveness

Public Service Loan Forgiveness requires borrowers to work for a nonprofit or government employer. There are several rules in this program:

• You must have Direct Loans.
• You must be on an income-driven repayment plan.
• You must work full-time for a qualifying employer.
• You must make 120 payments (a minimum of ten years).

2. State- or company-sponsored loan repayment assistance programs

These are state or employer-based forgiveness programs. Money awarded through these programs is usually considered ordinary income. Insolvency isn’t considered on the taxability of these programs.

3. Student loan cancelation and discharge

This is rare and unlikely for most borrowers. The programs that allow for your loans to be canceled for a variety of reasons fall into this category.  The reason behind the cancellation — for example, death and disability discharge — determines whether the loan cancellation is considered tax-free or not.

4. Long-term forgiveness under an income-driven repayment plan

Programs such as Income-Based Repayment, Pay As You Earn, Revised Pay As You Earn, and Income-Contingent Repayment falls into this category. Student loans forgiven through these programs are considered taxable income but can qualify for insolvency.

Income-driven repayment forgiveness tax bomb

If you agree to pay your student loans for 20 or 25 years, you might need to plan for a big tax bill. We typically recommend opening a taxable brokerage account and setting aside at least $100 per month into a brokerage account to prepare for this tax bomb.

More than ever before, it’s likely that the tax bomb could be waived for borrowers, but we don’t know that for sure yet.

Related: Tax Guide for Student Loan Borrowers

The bottom line

For most of the borrowers we work with, the insolvency rule won’t apply. That’s because one of our goals at Student Loan Planner is to look at your holistic financial picture and plan for retirement savings.

Similarly, we encourage borrowers to save for a potential loan forgiveness tax bomb. You can prepare for this slowly by investing monthly in a taxable brokerage account.

If a tax liability doesn’t apply to your situation, this strategy helps you build a nice nest egg for future goals. Having financial flexibility is definitely our preference over the insolvency rule or bankruptcy.