Public Service Loan Forgiveness (“PSLF”) altered the landscape of student debt management in 2007. This program, designed to rejuvenate the talent pool available for public service employers, provides tax-free loan forgiveness in exchange for 10 years of full-time employment in a public service job. If you hold a career in a public interest field, you are probably well aware of PSLF. But did you know that another type of loan forgiveness exists?
When it comes time to repay federal student loans, you must select one of seven repayment plans. In addition to the balance-based plans, designed to help borrowers pay off the entirety of their debt within a guaranteed period via a fixed payment, you will also have the option to choose from four “income-driven repayment plans.”
With Income-Driven Repayment (“IDR”) plans, your monthly payments are based on a portion of your income, regardless of how much debt you may have. Percentages range from 10 to 20 percent, and monthly payments are recalculated annually. IDR plans also have loan cancellation provisions written into their terms, which are significant because they enable you to cancel your outstanding loan balance after making payments for a set period of time.
So how long do you pay? Depending on the IDR plan you choose or qualify for, you will make payments for 20-25 years. While that is longer than the 10 years required for PSLF, IDR plans are far more flexible in terms of your employment. Under such a plan, you are not required to work in public service, work full time, or even work at all – since IDR plans base your payment amounts on income, an unemployed person can have monthly payments of $0, which still count toward loan cancellation – while making payments in order to qualify for cancellation.
However, there is one small hurdle worth discussing. Unlike PSLF, where the amount forgiven is not taxed, the amount cancelled under an IDR plan is taxed as cancelled debt. Here is how this works: after making your payments under the IDR plan for the required period of time, your loan servicer automatically notifies the Department of Education that it’s time for cancellation. Once notified, the Department of Education cancels the outstanding loan principal and interest, and mails a form 1099c, also known as a “Cancellation of Debt” form, listing the amount cancelled to you and the IRS.
According to the IRS, you are supposed to include the amount of cancelled debt marked on form 1099c as gross income to be taxed. However, this does not include amounts eligible for exclusion via the tax code. The major exclusion relevant to student debt is the “insolvency exclusion.” According to the insolvency exclusion, you get a dollar reduction in the taxable amount of cancelled debt for every dollar you are insolvent (meaning your liabilities – including the amount of student loans you seek to have cancelled – exceed your assets).
For example, imagine that Don has $150,000 in cancelled student loans, plus credit card debt ($10,000), a car note ($15,000), and a mortgage ($125,000), totaling $300,000 in liabilities. On the other hand, Don has assets including home equity ($75,000), car equity ($10,000), and a boat ($50,000), totaling $135,000. Don has $165,000 more in liabilities than in assets, meaning he is $165,000 insolvent. Because Don’s insolvency is larger than his $150,000 worth of cancelled loans, Don would not pay taxes on these cancelled loans.
However, let us assume that Don only had $250,000 in liabilities (including the $150,000 in cancelled loans) and $150,000 in assets. In this case, Don would be $100,000 insolvent. As a result, Don would be required to pay taxes on $50,000 of his cancelled loan amount instead of $150,000. This, however, is not the end of the story for Don. Because he is required to pay taxes on some of his cancelled loans, he is allowed to file an “Offer in Compromise” (“OIC”) and take advantage of installment agreements. An OIC would allow Don to determine the amount of the bill he could reasonably pay, based on his current financial situation and the tax bill established by the amount of his taxable cancelled loans.
While Don could make an OIC for any portion of the tax bill, an OIC of at least 10%-20% is recommended (and usually accepted), while anything lower than this may (and typically will) result in the OIC being rejected. For $50,000 in cancelled loans, Don could expect a tax bill of around $6,000. This means that through an OIC, Don could be responsible for around $1,200 of that tax bill. Luckily, the IRS offers generous settlement agreements for even that remaining $1,200 due. Under these settlement agreements, Don is automatically eligible for a 72-month repayment period, which could be extended if Don was willing to provide more detailed information about his financial situation.
In conclusion, IDR plans offer an additional, albeit more nuanced, version of loan forgiveness via their loan cancellation provisions. While this may require a little more paperwork, as Don’s example proved, you can still end up with tax-free or tax reduced forgiveness.
Equal Justice Works provides support to public interest attorneys, and helps law students learn more about all aspects of managing their student debt. We have a debt relief newsletter, free student debt webinars, and a free student debt e-book, Take Control of Your Future.
Kenneth Strickland is the Student Debt Specialist at Equal Justice Works. Here, he works to ensure that public interest legal jobs remain accessible to all who desire them by engaging in education, outreach, and policy analysis centered around ensuring that an affordable legal education remains an option for everyone. Ken is a recent graduate from the University of North Carolina School of Law, and has worked with reputable public service organizations such as North Carolina Advocates for Justice, American Civil Liberties of North Carolina, and the North Carolina Poverty Research Fund.