Tax Exclusion for Student Loan Forgiveness

This post fulfills the requirement enacted by Chapter 5 of 2023 (AB 111, Committee on Budget) that our office estimate the number of Californians who were able to exclude student loan forgiveness from state income taxation and the total amount of loan forgiveness excluded as a result of new, temporary income tax exclusions enacted by Chapter 5.

Background

Under Certain Conditions, Outstanding Student Loan Balances Are Forgiven. The federal government is the primary lender for college and graduate school loans. Student borrowers repay these loans through one of several repayment plans. Under some plans, outstanding loan amounts are forgiven after a borrower has made payments for a certain duration. In uncommon circumstances, such as when a college closes or defrauds students, outstanding loan debt may also be forgiven.

Federal and State Law Exclude Certain Types of Loan Forgiveness From Taxation. Federal and state tax law generally treat loan forgiveness as taxable gross income unless the loan forgiveness is specifically excluded. California has long excluded some federal student loan forgiveness from state income taxation. This includes loans forgiven under the federal Public Service Loan Forgiveness (PSLF) program, loans forgiven automatically after 20 or 25 years of repayment, and loans forgiven due to the borrower’s death or disability. State tax exclusions for several other federal loan programs have sunset in recent years. Specifically, exclusions for the Income-Contingent Repayment (ICR) plan, the Pay as You Earn Repayment plan, and the Revised Pay as You Earn Repayment plan sunset at the end of 2021. Exclusions for loans forgiven because the borrower’s school shut down or committed fraud sunset at the end of 2024.

2022 Plan to Provide One-Time Loan Cancellation

Biden Administration Proposed Plan to Cancel Up to $20,000 in Federal Student Loans. In 2022, the Biden Administration announced a plan to provide one-time cancellation of up to $20,000 in federal student loan debt for eligible borrowers. The plan sought to use authority under the existing federal Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act to cancel student loans. Under the HEROES Act (enacted in 2002), the U.S. Department of Education may waive or modify certain rules about student loan repayment for borrowers affected by national emergencies. In anticipation of a potential one-time loan cancellation, Congress included a blanket tax exclusion for student loan forgiveness in the American Rescue Plan Act of 2021 for loans forgiven between 2021 and 2025.

State Enacted Chapter 5 to Exclude One-Time Loan Cancellation From State Taxation. Following the announcement of the loan cancellation plan, the state enacted Chapter 5 to provide a state income tax exclusion based on the blanket federal exclusion. At the time, the Newsom Administration anticipated that 3.6 million California borrowers would receive $1.3 billion in state income tax relief from one-time debt cancellation. About this same time, the U.S. Supreme Court was hearing a challenge to the Biden Administration’s loan cancellation plan.

U.S. Supreme Court Rejected Biden Plan Shortly After Passage of Chapter 5. The U.S. Supreme Court ruled in Biden v. Nebraska (2023) that the HEROES Act did not authorize the large-scale loan cancellation plan. As a result, the one-time cancellation was not implemented, and no loans were canceled under the program.

With Biden Loan Cancellation Plan Rejected, Chapter 5 Provided Minimal New Tax Benefit. The potential for a large federal student loan cancellation effort led the state to enact Chapter 5. The U.S. Supreme Court then ruled that the HEROES Act did not authorize the cancellation plan. As a result, no associated loan forgiveness occurred, and no California borrowers received a new state income tax benefit under the Biden Administration plan to cancel loans. (Though Chapter 5 did not benefit millions of student borrowers as initially expected, it likely benefited a much smaller number of borrowers who received loan forgiveness under existing federal programs for which the state tax exclusion had expired.) In short, Chapter 5 did not provide notable state tax relief given the federal loan cancellation plan was never implemented due to a legal ruling.