President Joe Biden‘s student loan forgiveness plan will soon cancel debt for millions of Americans — and the relief is tax-free on federal returns. However, experts say the cancellation may still trigger a state tax bill.
Most borrowers making less than $125,000 per year or $250,000 for married couples filing together will qualify for $10,000 of forgiveness, with up to $20,000 of cancellation for Pell Grant recipients.
However, some states may count the canceled debt as income, explained Jared Walczak, vice president of state projects at the Tax Foundation.
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This may affect borrowers in more than a dozen states, adding a maximum state liability of roughly $300 to $1,100, according to Walczak, based on a preliminary analysis from the organization.
These states may include Arkansas, Hawaii, Idaho, Kentucky, Massachusetts, Minnesota, Mississippi, New York, Pennsylvania, South Carolina, Virginia, West Virginia and Wisconsin, the analysis shows.
‘Patchwork of approaches’ for state taxes
“Generally speaking, states use the federal tax code as a baseline for how they define taxability,” said Walczak, explaining how some use what’s known as “conformity” to follow certain federal legislation.
Some states have “rolling conformity,” updating state tax legislation as federal laws change, and others may only conform from a certain date, which may require updates to match the current law, he said.
In some cases, states may “decouple” from certain federal provisions to make the state tax code its own, Walczak said.
Since canceled debt is generally taxable, “there are a patchwork of approaches, most of which were not ever really about student loan debt,” he said.
State tax treatment of forgiveness may change
While the preliminary analysis shows some states may tax student loan forgiveness, there’s still time for policy changes, Walczak said.
“States could come back very early in the next legislative session, update their conformity statute and make it effective immediately,” he said.
And although it’s “clear cut” in some states, others may rely on administrative guidance or a regulatory ruling, Walczak said.
If you’re unsure, it’s best to speak with a local tax professional and watch for guidance from your state, he suggested.
“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.”