The Risks of Debt-Forgiveness Programs

With the ever-rising cost of education, students are forced to take on more and more debt. Some students may get through their undergrad nearly debt free, but if they want to continue their education, loans are often required to obtain a higher degree. Rising debt and a limited job market upon graduation have encouraged recent grads to enroll in debt-forgiveness programs.

Some of these debt-forgiveness programs allow students to pay back their federal loans with as little as 10% of their discretionary income each month over 20-25 years; after that period, the remaining balance is forgiven.

Such programs seem to provide a great solution; however, the fallout may prove to be too devastating.

When debt is cancelled, the amount forgiven is taken into income for tax purposes. The Internal Revenue Code has allowed an exception for certain student loan-forgiveness programs. In order to meet the requirements for the exception, the discharge of indebtedness must be subject to the individual working in a certain profession, for example, as a doctor for any public hospital in any rural area of the US.

However, the recent loan-forgiveness programs, Pay As You Earn (PAYE) and the Income-Based Repayment Plan (IBR Plan), base one’s loan payments on their annual income. These programs do not meet the requirements for the exception, and any amount forgiven must be taken into income in the year the debt is canceled. That means that at the end of the 20-25 year repayment period, these students will have to report their earnings, along with the amount forgiven, which will push them into higher tax brackets and potentially leave them with a tax bill they simply can’t afford.

Gregory S. Crespi, a law professor at Southern Methodist University, estimates that this fallout will occur around the year 2032, where these tax bills will often be in the neighborhood of $50,000 to $100,000, or even larger for those lawyers who have enrolled in the recently-implemented PAYE version of the IBR Plan, and in the neighborhood of perhaps $10,000 to $25,000 for those lawyers who have enrolled in the earlier-established “old IBR” version of the IBR Plan. Many of these lawyers will likely have failed to adequately provide for this large tax obligation and will find that it will impair, or even devastate, their retirement plans.

While this debt may fall on students of any discipline, Crespi argues that law students are particularly susceptible because those who pursue a legal education will graduate as a lawyer with over $150,000 in debt and no promise of future employment.

Crespi says that students should not count on Congress acting before 2032. He argues that the tax code should be adjusted to allow borrowers to pay their tax bill over a number of years without penalties.

Since nothing has been done to remedy this potentially harmful fallout, and it remains to be seen that anything will be done, we want our clients to know about the risks of debt-forgiveness programs so that they have a chance to think twice before signing up.

Please contact your BPW advisor at (805) 963-7811 if you have questions regarding the tax implications of debt-forgiveness programs.