I posted about this last year, but I think it bears repeating. Back in 2015, law professor Gregory Crespi coined the term “tax bomb” in reference to student loans. A “tax bomb” is oftentimes unexpected and seen when a taxpayer has surprise income that will be taxed. It can blow up a taxpayer’s taxes and result in money owed to the IRS. This concept of a “tax bomb” is also seen in retirement planning.
In the context of student loans, a “tax bomb” can be when a taxpayer has student loan debt that gets forgiven either through the Public Service Loan Forgiveness Program (PSLF) or Income Based Repayment (IBR). But, it becomes a bomb when the cancellation of student debt is viewed as income under 26 U.S.C. sec. 108(f) which results in a tax and requires payment to the federal government. However, in Professor John Brooks’ Tax Notes article, he confirmed that current interpretation allows an exception for PSLF, but not IBR. This means that if you have student loans forgiven under the PSLF program, then you will presumably not have to pay taxes. But, if you have student loans forgiven under IBR, then you may be stuck with a tax bill. The Treasury Department issued guidance on the issue in Rev. Proc. 2015-57. Brooks’ article does a great job explaining the nuances. Check it out here.
On a happier note, Senator Bob Menendez (D-NJ), Senator Elizabeth Warren (D-MA), Senator Ron Wyden (D-OR), Senator Debbie Stabenow (D-MI), and Senator Cory Booker (D-NJ) introduced the Student Loan Tax Relief Act which would exclude income created from the cancellation of student debt or student loan forgiveness. The bill is available here.