The Tax Treatment of Student Loan Discharge and Cancellation

Abstract

The standard view is that, absent an express exclusion in the tax code, cancellation of student debt is taxable. Under this view, any immediate debt relief through administrative action would generate a tax bill. More troubling, the millions of borrowers in Income-Driven Repayment could face a “tax bomb” because of their promised loan cancellation, potentially hitting borrowers with bills for $100,000 or more in the same year that the government tells them their loan obligations have ended. These perverse outcomes are, however, based on a misreading of the tax law. The standard tax treatment of debt cancellation does not work with student loans, for three principal reasons. First, the history of student debt cancellation reveals that for decades any cancellation was treated as a non-taxable “scholarship,” and that likely continues to be the law applied to student loan interest subsidies. Congress added the specific exclusion for Public Service Loan Forgiveness to the tax law in 1976 so as to overrule an erroneous IRS ruling and maintain this status quo, not to carve out a limited exclusion. Second, a “general welfare exclusion” applies to numerous government payments that have a purpose of promoting the general welfare, most particularly disaster relief payments. That same logic applies to student debt cancellation, both from IDR and administrative action. Third, the complex structure of student loans, especially those in IDR, raise serious and complicated tax law questions about the nature of the debt instruments, whether the liabilities are so contingent as to be outside the standard treatment, and indeed whether they would even qualify as “debt” for tax purposes in other contexts. For these reasons and others, Treasury and the IRS have sufficient legal authority to rule that they will not assert taxation against borrowers with cancelled student loans, and they should do so.