debt bomb

For those who are struggling to repay their federal student loans, there are alternative repayment plans available. The programs are known as Income Based Repayment (IBR) and Pay As You Earn (PAYE). These plans lower borrowers’ monthly student loan payments based on a percentage of their monthly income. If they stay on these plans for twenty to twenty-five years, then any balances remaining are forgiven.

While these plans sound tempting, there are caveats. First, these plans are not available for private loans, which includes companies like SoFi. Second, Lawyerist writer Lisa Needham warned that income-based student loan repayment plans are a trap. According to Jacob Gershman’s article in the Wall Street Journal, some will have to get ready for a hefty tax bomb once their federal student loans are forgiven starting in 2032.

The Treasury Department ruled that any federal student loans forgiven under the IBR or PAYE programs are considered taxable cancellation of debt (COD) income and must be reported on the borrower’s income tax return. However, if the taxpayer can show that he is insolvent, then he can reduce or eliminate COD income depending on the amount of his insolvency. Forgiven student loan debt is not taxable to those who complete the ten year Public Service Loan Forgiveness program.

This article will explain how the insolvency exception works and provide some strategies to defuse the tax bomb.

How the Insolvency Exception Works

When student loan debt is forgiven, the forgiving lender will typically issue a Form 1099C to the IRS and the borrower. The forgiven amount must be reported on the borrower’s tax return as income and the appropriate tax must be paid unless they can show that they are insolvent immediately before the student loan is forgiven. Then, their COD income is reduced by the amount of their insolvency.

A borrower is insolvent when their total liabilities exceed the fair market value of their assets. If their insolvency amount is greater than the student loan debt forgiven, then they can completely exclude the COD income. But if their insolvency amount is lower than the forgiven debt, then they must reduce the COD income by the amount of their insolvency and the remainder must be reported as income.

Assets are defined very broadly. These include assets that have an immediate, liquid value such as cash, stocks, and retirement plans. They also include assets with a disputable value such as real estate and ownership interest in a business or partnership. Finally, the IRS includes assets that are difficult to value such as clothing, household items, and tools.

Liabilities include current and past-due bills, student loans (including the federal loan being forgiven), and business loans. Contingent liabilities (for example, being a defendant in a lawsuit) are not considered liabilities unless there is a reasonable certainty that a liability will be created in the near future.

To illustrate, let’s look at the hypothetical status of three people.

Anna (Example One)

Anna is an attorney who has been paying her student loans through the IBR plan since its creation in 2007. Sometime in 2032, her federal loans of $80,000 will be forgiven. Immediately before her federal student loans are forgiven, she has the following assets and liabilities:

Anna's AssetsAnna's Liabilities
Total Assets: $83,400Total Liabilities: $174,400
Cash - $400Credit Card bills - $4,400
FMV of Car - $2,000Student Loans (Private) - $90,000
FMV of Personal Items - $1,000Student Loans (Federal) - $80,000
Retirement savings - $80,000

Anna is insolvent by $91,000 ($174,400 – $83,400). Her insolvency is greater than the federal loan forgiven ($80,000). In other words, Anna is still insolvent once her federal loans are forgiven. Therefore, Anna does not have to include any of the forgiven $80,000 as income on her 2032 income tax returns.

Bob (Example Two)

Bob is an attorney and has been on the IBR plan since 2007. In 2032, his federal student loans of $150,000 will be forgiven. Immediately before his federal student loans are forgiven, he has the following assets and liabilities:

Bob's AssetsBob's Liabilities
Total Assets: $640,000Total Liabilities: $715,000
Cash - $5,000 Credit Card bills - $15,000
FMV of Car - $25,000 Student Loans (Private) - $70,000
FMV of personal Items - $10,000 Student Loans (Federal) - $150,000
FMV of Home - $500,000 Home Mortgage - $450,000
Retirement savings - $100,000 Home Equity Line of Credit Balance - $30,000

In Bob’s case, his federal loan forgiven ($150,000) is greater than his total insolvency of $75,000 ($715,000 – $640,000). Therefore, he can only exclude $75,000 of the COD income because that is the extent of his insolvency. He must include the remaining $75,000 as COD income.

Carl (Example Three)

Carl is an attorney who has been on IBR since 2007. In 2032, his federal student loans of $60,000 will be forgiven. Immediately before loan forgiveness, he has the following assets and liabilities:

Carl's AssetsCarl's Liabilities
Total Assets: $640,000Total Liabilities: $625,000
Cash - $5,000 Credit Card bills - $15,000
FMV of Car - $25,000 Student Loans (Private) - $70,000
FMV of personal Items - $10,000 Student Loans (Federal) - $60,000
FMV of Home - $500,000 Home Mortgage - $450,000
Retirement savings - $100,000 Home Equity Line of Credit Balance - $30,000

Carl is completely solvent because the FMV of his assets are greater than his total liabilities. Therefore, he will have to include the forgiven amount of $60,000 as taxable income.

Basic Planning Strategies

To take advantage of the insolvency exclusion, you should make plans to minimize assets and maximize liabilities until the federal student loans are forgiven. This can be done in the following ways:

  • Gift away assets. Federal law allows a lifetime gift tax exemption for gifts up to $5.43 million. Gifts to spouses are not subject to gift taxes. On top of that, you can give away up to $14,000 per person annually without having to pay gift tax or reduce the lifetime exemption.
  • Lease, don’t buy. Rent an office. Lease a car. By renting instead of buying, you will minimize assets and create a liability.
  • Become an employee. If you own a law practice, you have an asset that can be difficult to value and gift away. Consider closing your practice while referring your existing clients to a friendly firm. That firm can then hire you as a non-equity employee such as an associate or a contract attorney. This can eliminate an asset while continuing to provide you with an income stream.
  • Defer income. To the extent possible, avoid taking new clients near the loan forgiveness date and advise clients and employers to defer paying you until the day after loan forgiveness. Of course, when dealing with untrustworthy individuals, it is better to get the money as soon as possible because it is better to take the money and pay a portion of it as income taxes rather than getting nothing at all.
  • Defer paying down liabilities. To the extent possible, do not pay your bills until the day after loan forgiveness. Work with creditors to advance the payment due date to the day after loan forgiveness without damaging your credit. Ask to waive late fees and interest.
  • Modify retirement plans. Consult with a financial planner to discuss transferring retirement accounts to others before loan forgiveness. However, be aware that nonqualifying transfers or distributions will create taxable income and an early withdrawal penalty.

Drawbacks of the Insolvency Exception

There are several pitfalls to be aware of when you are planning for insolvency. The first is economic. If you follow the above advice, you may be able to eliminate most of your COD income. But you may put yourself in a position where you will have large debts without cash or assets to pay them off.

Second, if your tax return is audited, expect the IRS to scrutinize your transactions closely. They will look for sham transactions that have no legitimate purpose other than to avoid taxes. For example, if the auditor sees that you gifted your assets to family and friends, he will try to look for any facts and circumstances that those assets will be re-gifted back to you after your loans are forgiven. If the agent notices anything suspicious, he may disregard your gifts as sham transactions and reclassify them as your assets.

Finally, the forgiven balance excluded from taxable income due to insolvency will be used to reduce favorable tax attributes. This includes business net operating losses, certain tax credits, basis in property and capital losses to name a few. Consult with a tax professional to find ways to use up these attributes before loan forgiveness.

The above advice is based on current law. But tax law and a person’s financial situation is likely to change between now and 2032. It is possible that student loans forgiven through IBR or PAYE can be tax-free through legislative action. Finally, after inflation, the tax bill might not be as painful as it seems.

I am sure many of you are dreaming about the day out in the distance when your federal student loans will be forgiven. So I offer the following fantasy: Before the big day, hold off on paying your bills for a little while. Your creditors can wait so long as you let them know. Get ready to sell the car and lease the Porsche you always wanted.

And to make that big day extra special, plan an exquisite two-week vacation. Spare no expense. Book a first class round trip flight to an exotic location and reserve an exclusive suite at a five star hotel. Dine on rare delicacies at Michelin Star restaurants.

Just be sure to pay for everything with a credit card before your loans are forgiven because someone will be picking up a portion of the tab.

Originally published 2015-08-05. Republished 2017-03-10.