Millions of Americans may soon have their debts forgiven thanks to President Joe Biden’s plan for student loan forgiveness, and the relief is tax-free on federal returns. The cancellation could, according to experts, nonetheless result in a state tax bill.
Most debtors who earn less than $125,000 annually—or $250,000 if they file jointly as a married couple—will be eligible for a $10,000 forgiveness, with Pell Grant recipients also being eligible for a $20,000 cancellation.
However, according to Jared Walczak, vice president of state programs at the Tax Foundation, certain states may classify the canceled debt as income.
According to Walczak, based on a preliminary estimate by the organization, this may have an impact on borrowers in more than a dozen states, increasing the maximum state liability by between $300 and $1,100.
According to the analysis, these states may include Arkansas, Hawaii, Idaho, Kentucky, Massachusetts, Minnesota, Mississippi, New York, Pennsylvania, South Carolina, Virginia, West Virginia, and Wisconsin.
State taxes: “Patchwork of approaches”
According to the White House, the American Rescue Plan of 2021 makes student debt forgiveness federally tax-free through 2025. The measure also applies to Biden’s loan forgiveness.
“Generally speaking, states use the federal tax code as a baseline for how they define taxability,” Walczak explained how some people follow particular federal legislation by engaging in what is known as “conformity.”
According to him, some states have “rolling conformity,” updating state tax regulations when federal laws change, while others may only comply as of a specific date, necessitating revisions to reflect the most recent law.
According to Walczak, states may occasionally “decouple” from specific federal laws to create their own state tax laws.
Considering that canceled debt is typically taxed, “there are a patchwork of approaches, most of which were not ever really about student loan debt,” he mentioned.
The way that state taxes treat forgiveness may vary
There is still time for legislative reforms, despite the early analysis’s finding that certain states may tax student loan forgiveness, according to Walczak.
“States could come back very early in the next legislative session, update their conformity statute and make it effective immediately,” he said.
Additionally, Walczak said that while it may be “clear cut” in some jurisdictions, others may rely on administrative guidance or a regulatory decision.
He said that if you’re unclear, it’s advisable to speak with a local tax expert and keep an eye out for direction from your state.
“This is not a niche issue that only affects a few people,” Walczak said. “It affects a very large number of people and hopefully, there will be clarity provided on it.”