Foundation research

Tax Treatment of Student Loan Debt Cancellation

President Biden’s announcement of student loan debt cancellation already raises many questions. How much will it cost? Who will benefit the most? How will it contribute to inflation? Does the president even have the legal authority to implement this loan forgiveness?

Here’s another question to add to the mix: Will states consider student loan debt forgiveness a taxable event? In many states, the answer might be yes.

Generally, debt forgiveness counts as income and is taxable, as my colleague Will McBride explains. Under Section 9675 of the American Rescue Plan Act (ARPA), however, cancellation of student loan debt between 2021 and 2025 does not count as federal taxable income. States that follow the federal treatment here will also exclude debt cancellation from their own income tax bases. But, for various reasons, not all states do this. There are at least six relevant interactions with the Internal Revenue Code (IRC) for the purpose of processing student debt forgiveness. States can:

  1. Compliant with current version of IRC with ARPA (exempt)
  2. Compliant with the current version of IRC but decoupled from ARPA (taxable)
  3. Not fully compliant with current IRC but introduce relevant ARPA provision (exempted)
  4. Not fully compliant with current IRC but separately excludes student debt cancellation (exempt)
  5. Complies with a pre-ARPA version of the IRC (taxable)
  6. Selectively comply with IRC or adopt an independent definition of (taxable) income

As a preliminary, it appears that 13 states have the potential to tax student loan debt discharged, although the final tally could be significantly lower if states make legislative changes or administratively determine that debt forgiveness can be excluded, or if compliance dates are updated retroactively.

The table below lists the states that may tax student loan debt and the maximum realistic amount of additional tax that could result. Generally, this means the highest marginal rate, even if it slightly exceeds the $125,000 (single) / $250,000 (married) threshold for debt cancellation, since borrowers have the option of choosing a base year 2020 or 2021 for eligibility purposes and may have higher income now. But, admittedly somewhat arbitrarily, I excluded rates that triggered at thresholds above $200,000 for single filers.

Why – except in two cases – the higher marginal rate? Because even if it will not be the amount paid by all taxpayers benefiting from debt forgiveness, it will apply to many of them. A significant portion of student debt is held by people with high earning potential who may already be on track for those big paychecks. Moreover, even with an eligibility limit of $125,000 for single filers and $250,000 for married couples, it is possible for someone to earn more than that and still benefit, since taxpayers have the choice to use their 2020 or 2021 income to determine eligibility. A large legal partner who was a second-year married associate in 2020 could have well over $250,000 in family income now and still be below the threshold in 2020.

And while not the typical beneficiary, many will have additional income subject to the states’ top marginal rates, which often kick in at middle or lower income levels.

Conversely, it is of course possible for someone to have made less than $125,000 in 2020 and to be making $280,950 now (Wisconsin’s highest rate threshold), or even the $1,077,550 necessarily to move into higher brackets in New York. However, these cases will be sufficiently exceptional for me to include them in the following table. The total amount of $10,000 is covered; amounts can be doubled for Pell Grant recipients with $20,000 of debt discharged.

Potential State Taxation of Canceled Student Loans Assumes Cancellation of $10,000 Debt
State Probable Maximum Tax Liability
Arkansas $550
Hawaii $1,100
Idaho $600
Kentucky $500
Massachusetts $500
Minnesota $985
Mississippi $500
New York* $685
Pennsylvania $307
Caroline from the south $700
Virginia $575
West Virginia $650
Wisconsin* $530

* The calculation in these states does not assume the highest marginal rate as it would apply to relatively few eligible recipients.

Sources: Tax Foundation analysis.

Note that while the debt – if retained – would have been paid over a period of years, the forgiveness of the debt is included in income in the year it is taxed.

In the weeks and months to come, we’ll likely see states release guidelines on how to deal with discharged student loan debt. New York in particular is difficult to assess, as the state generally follows the federal definition, but has administratively determined that student debt discharged due to death or disability, and therefore canceled under the ARPA, should be added back to taxable income, but is silent on debt discharged for another reason (or no specific reason) under ARPA. It would seem likely that if New York weren’t following the federal treatment in these narrower cases, it wouldn’t be doing so under a less targeted policy, but it’s hard to be sure.

At this point, the analysis should never be construed as tax advice, but that’s especially true here. While this represents my best interpretation of how states are likely to treat student loan debt as of the date of publication, this list should not be relied upon for tax purposes. In the absence of direct state guidance on handling student debt relief, affected taxpayers should consult with a tax preparer.