Tony Bartels 288

Photo by Audra Fenimore

Dr. Tony Bartels, pictured with his dog Addi on Handies Peak in Colorado, is the student debt consultant at the Veterinary Information Network, an online community for the profession.

If you have student loan debt and are heading toward forgiveness through an income-driven repayment program, you may have felt a surge of excitement when you learned the American Rescue Plan Act of 2021 included a tax exemption for canceled student loans. I do, and I did. Then I studied the fine print and discovered this rule won't apply to me or to many like me.

The $1.9 trillion economic stimulus bill aimed at relieving the continued impact of the pandemic, signed March 11, includes Section 9675 for the "modification of treatment of student loan forgiveness."

The new provision changes how the IRS treats canceled student loans. Normally, canceled debt is included in your gross income and subject to income tax. The modification excludes canceled student loans from your gross income if that loan forgiveness occurs between 2021 and 2025. The gross income exclusion applies to federal loans made for postsecondary educational expenses and, it appears, private loans made for the same purpose.

The most common way for student debt to be forgiven, or canceled, is when borrowers who have been making payments based on a percentage of their income reach the maximum repayment period, 20 or 25 years, with a balance remaining. Unfortunately, there are very few people who have received student loan forgiveness using an income-driven repayment plan. There are a couple of key reasons for that, most of which have not been mentioned in early analyses I've read of the new loan forgiveness modification.

The most beneficial income-driven repayment plans, the ones most likely to result in forgiveness, have not been around long enough for an appreciable number of people to qualify.

To explain why, I need to take a step back.

There are four federal income-driven repayment plans that can result in forgiveness: Income-Contingent Repayment (ICR), Income-Based Repayment (IBR), Pay-As-You-Earn (PAYE), and Revised-Pay-As-You-Earn (REPAYE). While they are similar in principle — you make payments based on your income and family size until you either pay the balance to zero or you reach forgiveness after a specified number of payments — they also have significant differences.

ICR has been around the longest. It was first available to borrowers in 1995. The earliest that borrowers under ICR could have become eligible for loan forgiveness was 2020.

Regrettably, ICR didn't provide much in payment relief for those who may have been eligible to use it back in 1995. The monthly payments were 20% of the borrower's discretionary income, a relatively high proportion. Therefore, most borrowers under ICR either paid off their loans before reaching forgiveness or switched to a repayment plan that provided a lower monthly payment but did not result in forgiveness.

When I read a policy report by the National Consumer Law Center stating that only 32 borrowers have so far received income-driven student loan forgiveness, I thought to myself, "Wow, there are that many?" The report is being cited by many as a testament to how terrible the federal student loan repayment system has been. And I certainly agree that there are significant problems we need to solve. However, the statement that only 32 people have received forgiveness to date should not be surprising to anyone who's followed the progression of income-driven repayment.

ICR was income-driven repayment version one. Think of it as the flip phone of income-driven repayment. I certainly wouldn't expect the flip phone to connect to the internet, store multi-gigabyte pictures, make video phone calls, provide driving directions, schedule life and have a battery that would last all week. The same is true for ICR — it was the start of something that has improved over time and will likely continue to improve. It has to. Even if the current administration canceled all $1.6 trillion dollars of student debt, there will still be a need for student loans and reasonable repayment plans to manage those loans.

Compared with ICR, the newer versions of income-driven repayment provide for lower monthly payments (10-15% of discretionary income) and have shorter repayment periods. Therefore, they are more likely to result in forgiveness, particularly if you owe more than your annual income.

The newer options did not become available until 2009 (IBR), 2012 (PAYE), 2014 (new IBR), and 2015 (REPAYE). The earliest that borrowers who started repayment under any of these plans will qualify for forgiveness is 2032. That is seven years after the new forgiveness tax exemption expires.

When ICR started, most federal student loans and borrowers were ineligible for income-driven repayment and forgiveness.

Prior to 2010, there were two main federal student loan types available: Federal Family Education Loans (FFEL) and Direct Loans. All income-driven repayment plans except for the original version of IBR apply only to Direct Loans. However, at the end of 2010, 73% of all federal student loan borrowers held FFELs, representing 69% of the total balance at that time. I will never understand why the predominant loan type was excluded from nearly all of the income-driven repayment plans. This was one of the original sins associated with federal student loans, income-driven repayment and forgiveness eligibility.

Borrowers have been able to consolidate FFELs into Direct Loans for a number of years. Sadly, unless they knew why they should and how to do it, or were provided helpful guidance from their loan servicer, they were unlikely to consolidate FFELs into Direct Loans specifically for income-driven repayment or forgiveness purposes. If you have federal student loans, unfortunately, you know too well how unlikely it is — to the point of laughable — to receive helpful guidance from your loan servicer. And if you did navigate a Direct Loan consolidation, there is a really good chance that you lost some or all of your forgiveness credit, since consolidation restarts the forgiveness progress. Non-qualifying loan types and repayment plans, as well as unhelpful loan servicers, are some of the same reasons that we saw confusion and low qualification rates among early applicants of the non-taxable version of student loan forgiveness, Public Service Loan Forgiveness.

Of all federal student loans in repayment, only 3% are currently paid using ICR. Within that modest fraction, are there some who had Direct Loans or successfully navigated a Direct Consolidation Loan, started in ICR between 1995 and 2000, still have student loans, and find themselves close to forgiveness? Maybe. It would take quite the special alignment of events to fall into that small group, though.

There are also an unknown number of borrowers who may have started in ICR and managed to switch to a more beneficial income-driven repayment plan in 2009 or later who may benefit from the forgiveness tax exemption allowed in 2021-25.

Going back to the 3% in ICR: Included in and complicating those stats are Parent Plus borrowers. ICR is the only income-driven repayment plan that parents can use to earn forgiveness on federal student loans they borrowed to help pay for their children's education. (The fact that parents can use only ICR among all the income-driven repayment plans is another pill poisoning federal student loan repayment.) 

Ultimately, knowing exactly how many borrowers are headed for student loan forgiveness and when is extremely difficult since there is not yet a good way to track the number of years borrowers have made qualifying forgiveness payments. This, as well as enabling parents to use more beneficial income-driven repayment plans, are things that Congress, the U.S. Department of Education and the loan servicers need to fix as soon as possible.

So how, then, do we make sense of the short-term tax modification?

There is reason to be excited, confused and frustrated with the student loan forgiveness modification.

Excited: I think this modification makes it more likely that we'll see some kind of student debt cancellation in the short-term by executive or legislative action. If so, whether you have federal or private student loans, whatever amount might be canceled would most likely not be subject to federal taxation.

The modification also opens the door to exempting student loan forgiveness from taxes permanently.

Confused: Not only is the universe of borrowers who will benefit from the new exemption too small, but the law makes no provision for borrowers who reached forgiveness through ICR in 2020. So any poor soul who managed to have their loans canceled in the most recent tax year will have to pay a tax when they file, making them completely screwed by the structure of this amendment. Thankfully, there are probably very few to no souls in that situation.

The modification also makes it possible to screw people in the future if Congress does not continually extend or make the tax exemption permanent by the time most borrowers experience student loan forgiveness. Essentially, we've now made student loan forgiveness a political football, which leads me to the frustrating parts of the modification.

Frustrated: Handling forgiveness in this piecemeal way makes for even more frustration around student loan repayment. It's similar to how forgiveness under Public Service Loan Forgiveness was reached by fewer than 1% of applicants early on because Congress applied convoluted rules around the qualifying loan types and repayment plans.

If they know there will be a tax on their student loan forgiveness, borrowers can plan for it by saving money to cover that bill. However, many borrowers need the entire maximum repayment period to have a chance to save enough. If there's not a tax in the future, great! That's less to worry about in repayment and more room to focus on other areas of financial wellness.

However, Congress has arguably made it more likely that borrowers will fail to plan or consider saving for a tax that they may still have to pay. That might be genius on the part of the senators who think they have a crystal ball showing that the forgiveness modification will certainly be extended. Or it is completely irresponsible if the provision expires as scheduled — and people who had been lulled into believing the tax exemption would be extended lose at least five years to save for the potential tax bill.

Outside of borrowers defrauded by for-profit colleges who will have their loans canceled, or any one-time student loan cancellation that may occur in the next four years, the modification only creates more anxiety for the millions of borrowers using income-driven repayment around what will happen after 2025.

My wife and I have $400,000 of veterinary school student loans we manage using REPAYE. We are due to reach forgiveness in 2037. When word of the modification surfaced, we briefly mused about what we might do with our forgiveness fund if we no longer had to pay the tax. Then we saw the devil in the modification details. There is no way we can stop planning for the forgiveness tax. What little certainty we had before around the tax has now been replaced with greater uncertainty and elevated expectations that the tax should be eliminated going forward.

So what do we do now? Plan for the worst and hope for the best. If your student loan forgiveness will be outside the new modification window (which is the case for nearly all outstanding student loan balances), then keep planning for the tax on your student loans and keep your fingers crossed that we see some type of cancellation in the next five years or a permanent extension of the forgiveness modification.

About the author: Tony Bartels graduated in 2012 from the Colorado State University combined MBA/DVM program and is an employee of the Veterinary Information Network. He and his wife, a small animal internal medicine specialist practicing in Denver, have more than $400,000 in veterinary-school debt that they manage using federal income-driven repayment plans. By necessity (and now obsession), Tony's professional activities include researching and speaking on veterinary-student debt, providing guidance to colleagues on loan-repayment strategies and contributing to VIN Foundation resources. Beyond debt, his professional interests include small animal practice. When he's not staring holes into his colleagues' student-loan data, Tony enjoys fly fishing, camping and exploring Colorado with his wife, Audra, and their two rescued canines, Addi and Maggie.