Defusing the Student Loan Forgiveness Tax 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.


  1. I plan on bookmarking this, studying it in detail (I skimmed this time), and crying tears of sadness in the near future. Any advice on whether starting a non-profit law firm might be a better option? A firm in Salt Lake City did just that.

    Shorter repayment period. Tax-free forgiveness. Only downside is that compensating yourself adequately seems more difficult.

  2. Avatar Aisu says:

    This situation was obviously an oversight by Congress and I am sure the law will change on this issue by the time the loans are forgiven.

  3. Avatar olive says:

    My husband and I, both lawyers, have around $220k in loans EACH. We both consolidated our loans for IBR during the same year. Which means that both of our loans will be forgiven the same year. Do you see where I’m going here? Someone please say something to stop my heart palpitations

    • Avatar Steven Chung says:

      2032 is eighteen years away. Plenty of time to plan.

    • Avatar Latife Neu says:

      Down the road, you could consider getting one of you on the standard repayment plan (if feasible) for a year to trigger tax forgiveness over the course of 2 years rather than one. Put it on the calendar to think about in 2027 or so, and enjoy IBR in the mean time.

      • Avatar Steven Chung says:

        My understanding is that you cannot temporarily get off of IBR or PAYE. You have to be on the program continuously for the 20/25 year period.

        • Avatar Overtaxed Lawyer! says:

          My FFEL Consolidated loan began in 1994. Intermittently, i’ve been in IBR or Income Sensitive Repayment for a total of about 17 years, 8 months, but rest of the time (4 years, 1 month) was in forbearance. The longest Repayment period without an intervening Forbearance was 9 years. I always thought I could count all the repayment periods toward the 25 years. Not true?

          BTW, this is a GREAT article and great resource, and I’m so grateful for it because I’m really worried about the huge tax debt if my loan is forgiven. I borrowed $85,000, I’ve made total payments of $126,000, and I now owe $213,000. :-(

  4. Avatar Krystov says:

    One thing that concerns me about the strategy set forth in your article is that it seems so similar to the manufactured insolvency that fraudulent transfer law is designed to prevent.

  5. Avatar Latife Neu says:

    Discharge granted for disabled borrowers under the DOE’s Total & Permanent Disability (TPD) discharge option also creates a taxable event in the year the debt is discharged. This is happening now– not 25 years in the future. Thanks for a great article, Steven!

  6. Avatar Cole Combs says:

    It puzzles me that all of the examples show rather significant retirement savings, and yet after THREE DECADES they still owe on their student loans? Maybe I’m crazy, but if you haven’t earned enough to pay off your debts after that much time working then perhaps you shouldn’t be practicing law to start with. Two of the examples even have a home worth $500k. The payments on that are certainly more than just paying off your student loans.

    I also concur with Krystov. The article seems to be suggesting fraud to avoid debt. Even if no one could ever prove it’s legally fraud it’s still damn well moral fraud.

    • Avatar TheRealSocialmedic says:

      The real fraud is bankrupting the economy in order to pander to the top 1% and then shoving the responsibility for the cost of education on to the backs of the students. Furthermore, the fraud is robbing the loan program of its bankruptcy, consumer protections and statute of limitations. Obviously American society doesn’t give a damn about education or its children or democracy for that matter. They’d rather bury their heads in the sand, vilify the people who do the WORK of studying to get their degrees and kiss the asses of the people who hoard the nation’s wealth while giving nothing back in return.

  7. Avatar J-dawg says:

    Trying to decide whether I want to take a doc review job that will put me on IBR or hold out with my smattering of random part-time non-legal jobs until I manage a PI position. Same income, but no bomb on what will eventually be over $400k in loans + interest (since IBR won’t even cover the interest on what I have).

  8. Avatar Jason says:

    thanks for this. this might sound like a stupid question, but: if you are just beginning PAYE, and you have an estimate of how high your tax liability will be when you reach forgiveness, is it financially wiser to a) save a bit each year in a special “tax bomb” account or b) arrange ones finances towards insolvency? a) seems like the obvious answer but i wonder if there are pitfalls to that (ex. you don’t manage to save enough to pay the whole “tax bomb,” and then you’ve got more assets preventing you from insolvency.)

    • Avatar Steven Chung says:

      If you just started PAYE, then it’s hard to say. But if you have a large amount of cash, then I’d save some of it for the tax bomb. If you have a house with equity, then I’d just take out a loan against it and use the proceeds to pay off the debt. If you have a spouse with little to no debt, then I’d contribute to her retirement account. Wait about 10-15 years and see where you are at financially.

  9. Avatar Andrew says:

    I think legislative action will happen, probably a year or two before
    the first IBR/PAYE loans are set to be forgiven. By that time, most of
    the Boomers will be dead [most do not have student loans and many would oppose such reform, anyway]. With the Boomers gone, a good
    portion of the electorate will still have student loans and candidates for office will appease this voter base.

    I honestly would not worry about how to pay off your large student loan. Our country in another 15-20 years from now will be different than it is today.

    In the meantime, I would try to use these programs to pay as little as possible towards student loans, unless you have under $10,000 in student loans. Instead, look to put money into retirement and start building equity.

  10. Avatar Tomoko says:

    Thanks for the great article for those of us who like to plan. My question is: Where does the 10s of $1000s interest fall in all of this? Forgiven and considered part of the liability? You examples seem to only consider the actual loan amount.

  11. Avatar Erin Rauch says:

    Very Helpful! Thank you for this article!

  12. Avatar Andrew N Kingsley says:

    Great article, I’m a disabled veteran and I just filed for student loan discharge. I was confused about the insolvency issue. Now that I understand that I can include my student loan debt pre-discharge, I will have no issues proving insolvency.

  13. Avatar Ruth Bowen says:

    I’m curious if cash values in a whole life insurance policy would be considered an asset?

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