How to calculate the IBR tax consequences Forum

[The Duck]

Because this is commonly overstated:

For debt forgiven under the 10-year IBR program (PSLF), there is no tax consequence.

For debt forgiven under the longer program, the tax is calculated as follows:

You're only taxed on forgiven debt to the extent that it exceeds insolvency. (Total of liabilities minus FMV of assets.) Also, the capitalized interest is not taxable to the extent it would be deductible if you paid it.

http://www.irs.gov/pub/irs-pdf/p4681.pdf

So, $200K in principal on loan, $50K in assets, $500K forgiven (principal and interest)...you'd be taxed on $50K.

$200K principal, $250K in assets, $500K forgiven...you'd be taxed on the principal and non-deductible interest. (Good luck figuring out how to calculate that under the current regs.)

This is still a tax bomb...but it isn't nearly as big as people make it out to be. It should be considered, however, as it undermines your ability to build assets (like retirement savings) later in life.

Edit: I should add...there is also a risk that Congress gets rid of this and you're on the hook for the accrued interest. There is no grandfather clause keeping the program as to current recipients if it is repealed.

[2014]

You make a good point but it still effectively prevents you from amassing wealth as you said. For anyone who makes an attempt to put money to retirement, kids college funds, a house, etc the policy still effectively forces bankruptcy at the 20 year mark for a lot of people unless they have the foresight to horde money in something more liquid than a house for example. (People as a whole have proven to lack this common sense in the past)

Good to know about the interest not being taxed though. I'll take your word for it without reading the pdf

[Tiago Splitter]

Are you sure about the interest never being taxable? Since only $2,500 per year can be deducted, and that phases out after AGI exceeds 75K, it seems like a heck of a deal.

As you say Congress could take this away at any time. But it's also important to note that since no one has gone through this, there aren't any PLRs or anything else clarifying the IRS' attitude towards 20 year loan forgiveness.

[The Duck]

Are you sure about the interest never being taxable? Since only $2,500 per year can be deducted, and that phases out after AGI exceeds 75K, it seems like a heck of a deal.

As you say Congress could take this away at any time. But it's also important to note that since no one has gone through this, there aren't any PLRs or anything else clarifying the IRS' attitude towards 20 year loan forgiveness.

To the extent the interest is deductible, it falls under the deductible debt exception. (There is an "interest included" section which references that exception that appears later.) I suppose you're correct that excess would be taxable (but would likely exceed assets.)

I'll edit

[Tiago Splitter]

Are you sure about the interest never being taxable? Since only $2,500 per year can be deducted, and that phases out after AGI exceeds 75K, it seems like a heck of a deal.

As you say Congress could take this away at any time. But it's also important to note that since no one has gone through this, there aren't any PLRs or anything else clarifying the IRS' attitude towards 20 year loan forgiveness.

Yep, look at the PDF. It falls under the deductible debt exception. (There is an "interest included" section which references that exception that appears later.)

The PDF says "you do not realize income from the cancellation of debt if the payment of debt would have been a deductible expense." For many people none of their interest would be a deductible expense (if they make over 75K) and for many others only a portion of the interest would be deductible.

That said, interest won't always matter since according to your formula many people will just be taxed on the FMV of their assets.

[The Duck]

Are you sure about the interest never being taxable? Since only $2,500 per year can be deducted, and that phases out after AGI exceeds 75K, it seems like a heck of a deal.

As you say Congress could take this away at any time. But it's also important to note that since no one has gone through this, there aren't any PLRs or anything else clarifying the IRS' attitude towards 20 year loan forgiveness.

Yep, look at the PDF. It falls under the deductible debt exception. (There is an "interest included" section which references that exception that appears later.)

The PDF says "you do not realize income from the cancellation of debt if the payment of debt would have been a deductible expense." For many people none of their interest would be a deductible expense (if they make over 75K) and for many others only a portion of the interest would be deductible.

That said, interest won't always matter since according to your formula many people will just be taxed on the FMV of their assets.

You're right...see edit. I forgot about the phase out.

Although how would you calculate this? Is it the interest you would have paid had you completed a 30-year repayment? Just $2,500 or whatever you'd get that year?

[sunynp]

I didn't see anything about IBR forgiveness in that PDF. Am I missing something? Why are you assuming that this debt will be treated the same as other debt? I did see a subsection on forgiving student loan debt that exists already. Is there something in the legislative history or otherwise that leads you to this conclusion?

I don't know if the IRS is going to address this for another 18 years or more.

[The Duck]

I didn't see anything about IBR forgiveness in that PDF. Am I missing something? Why are you assuming that this debt will be treated the same as other debt? I did see a subsection on forgiving student loan debt that exists already. Is there something in the legislative history or otherwise that leads you to this conclusion?

I don't know if the IRS is going to address this for another 18 years or more.

I'm not assuming anything...its the internal revenue code. Its forgiven debt. § 61 makes it income (like virtually everything). PSLF is covered under a separate section providing an exception. § 108 provides the insolvency exclusion. If someone else who has taken tax disagrees...please feel free to prove me wrong.

(a) Exclusion from gross income
(1) In general
Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—
(A) the discharge occurs in a title 11 case,
(B) the discharge occurs when the taxpayer is insolvent,
(C) the indebtedness discharged is qualified farm indebtedness,
(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013.

...

(3) Insolvency exclusion limited to amount of insolvency
In the case of a discharge to which paragraph (1)(B) applies, the amount excluded under paragraph (1)(B) shall not exceed the amount by which the taxpayer is insolvent.

It's also worth noting I didn't pull this from thin air...it's what every tax scholar discussing the subject has concluded. I'm just restating it because while I personally think IBR is a bad idea for most...people should use the right consequences when evaluating their choices. Congress would have to amend the tax code to exempt it from § 61's reach and § 108's exclusion.

The IRS won't promulgate regulations until then because otherwise Congress would have to admit that it has no way to pay for this and that it will impose a hardship on taxpayers..

[dnelson]

Would someone be so kind as to explain this in simpler terms? Everything I've seen concerning IBR has been positive, but that has put me on the lookout for something negative about it. Seems like I've come across something, but I'm an undergraduate senior and don't quite understand the tax lingo.

My decision for law school might very well based on whether IBR is a good plan or not...I'd definitely be willing to take out more in loans (and attend a better school) if I could have my payments capped after graduation. But if there's some kind of tax bomb, I might have to change my plans.

Who would be most authoritative on this issue? A tax attorney?

[The Duck]

Would someone be so kind as to explain this in simpler terms? Everything I've seen concerning IBR has been positive, but that has put me on the lookout for something negative about it. Seems like I've come across something, but I'm an undergraduate senior and don't quite understand the tax lingo.

My decision for law school might very well based on whether IBR is a good plan or not...I'd definitely be willing to take out more in loans (and attend a better school) if I could have my payments capped after graduation. But if there's some kind of tax bomb, I might have to change my plans.

Who would be most authoritative on this issue? A tax attorney?

Its simple. When a debt you owe is forgiven, that counts as income and is taxed as if you earned it. There is an exception, that forgiven debt is only taxed to the extent it doesn't exceed your solvency (FMV of all of your assets minus any debt you owe...your net worth). So, if you are worth $50K, and they forgive $200K, they will add $50K to your salary that year when forgiven. If you are worth $100K and you made $40K, they will tax you as if you made $140K the year it is forgiven. This will result in a much higher tax bill and necessitate you paying the IRS tens of thousands of dollars (depending on the amount that counts towards taxes).

Call a CPA or a tax attorney. The problem is, no one knows for sure. This is how it would work under the normal default rules. Congress could create an exception but they haven't done so yet and won't likely address it for 20 years when the first people come up for forgiveness. So, its a gamble.

[dnelson]

Would someone be so kind as to explain this in simpler terms? Everything I've seen concerning IBR has been positive, but that has put me on the lookout for something negative about it. Seems like I've come across something, but I'm an undergraduate senior and don't quite understand the tax lingo.

My decision for law school might very well based on whether IBR is a good plan or not...I'd definitely be willing to take out more in loans (and attend a better school) if I could have my payments capped after graduation. But if there's some kind of tax bomb, I might have to change my plans.

Who would be most authoritative on this issue? A tax attorney?

Its simple. When a debt you owe is forgiven, that counts as income and is taxed as if you earned it. There is an exception, that forgiven debt is only taxed to the extent it doesn't exceed your solvency (FMV of all of your assets minus any debt you owe...your net worth). So, if you are worth $50K, and they forgive $200K, they will add $50K to your salary that year when forgiven. If you are worth $100K and you made $40K, they will tax you as if you made $140K the year it is forgiven. This will result in a much higher tax bill and necessitate you paying the IRS tens of thousands of dollars (depending on the amount that counts towards taxes).

Call a CPA or a tax attorney. The problem is, no one knows for sure. This is how it would work under the normal default rules. Congress could create an exception but they haven't done so yet and won't likely address it for 20 years when the first people come up for forgiveness. So, its a gamble.

I see. Thanks. Here's a hypothetical I'd like to check just to make sure I understand:

If you originally borrowed $150,000, entered into the IBR with $50,000/year in discretionary income, assuming there are no raises, you would pay back about $7,500 per year (15% of your discretionary income/year). Right so far?

Since forgiveness occurs after 25 years, you pay back a total of $187,500. What is the best way to determine how much there will be remaining at this point? Don't you need to know this number before you can calculate how much will be forgiven? It will likely be astronomical, right, like $200,000 remaining or something...? I assume with such lower payments over those 25 years, the interest must have skyrocketed...

[dnelson]

Actually, this link helped explain things.

http://www.projectonstudentdebt.org/fil ... ess_ex.pdf

Although none of the examples they provide originally borrowed three times their annual discretionary income (as in my example), it is pretty easy to see that with $150,000 in loans and income of only $50,000/year, the amount remaining after 25 years would probably be around $200,000.

And none of this even takes deductible interest into account. That complicates things even further...

[2014]

Dnelson don't think the tax bomb suddenly makes IBR terrible. The program is necessarily a good thing for those taking advantage of it as without it you would be on the hook for more money than you could possibly pay back. The tax bomb is an unfortunate consequence, but there is no way that it is worse than actually paying the full amount.

[taxman128]

http://www.answers.com/topic/tax-benefit-rule

"1. if a taxpayer recovers an amount that was deducted or credited against tax in a previous year, the recovery must be included in income to the extent that the deduction or credit reduced the tax liability in the earlier year. If no tax benefit was derived from a prioryear deduction or credit, the recovery does not have to be included in income.


2. if a taxpayer repays an amount that was previously included in taxable income, the repayment can be deducted in the year in which it is repaid.

Read more: http://www.answers.com/topic/tax-benefi ... z2EOv6oaoj"

would second sentence of paragraph 1 exclude forgiveness of interest that could not be deducted?

thanks

[wingding]

One thing to keep in mind is that both tax and bankruptcy laws change, and calculating the results based on current treatment is unwise.

[Kronk]

Can someone explain this to me in dumb-person words?

If I own a home that is worth $400k and have $50k in savings, do I have $450k in assets and thus I would be taxed on $450k if, for example, my loan principle is $280k and I do PAYE and the forgiveness ends up being $650k?

[bearsfan23]

Can someone explain this to me in dumb-person words?

If I own a home that is worth $400k and have $50k in savings, do I have $450k in assets and thus I would be taxed on $450k if, for example, my loan principle is $280k and I do PAYE and the forgiveness ends up being $650k?

How on earth would you loan forgiveness end up at $650k from a $280k principle? One of the major points of PAYE is that interest DOES NOT capitalize during repayment.

I don't have an answer to the assets part, but just wanted to point out you might want to re-adjust your figures (unless there are additional loans I really can't see the total rising above $400k, but I'm sure there's a better way to calculate it)

[Kronk]

Can someone explain this to me in dumb-person words?

If I own a home that is worth $400k and have $50k in savings, do I have $450k in assets and thus I would be taxed on $450k if, for example, my loan principle is $280k and I do PAYE and the forgiveness ends up being $650k?

How on earth would you loan forgiveness end up at $650k from a $280k principle? One of the major points of PAYE is that interest DOES NOT capitalize during repayment.

I don't have an answer to the assets part, but just wanted to point out you might want to re-adjust your figures (unless there are additional loans I really can't see the total rising above $400k, but I'm sure there's a better way to calculate it)

My figure were slightly off. myfedloan.org estimates the eventual repayment would be $531k on my $280k principal under PAYE. The interest doesn't capitalize, but on a $280k principle at an average of like 7% on the loans, it's still accumulating at almost $2k a month for 20 years. I am shit with taxes / interest / etc. stuff but that's my understanding, and it seems reflected on the repayment estimator on myfedloans.org.

[Tiago Splitter]

280k*07=19200. Times 20 years gets you to 672k, make some payments along the way and its lower obviously

kronk youd pay tax on 450k in your scenario

[Kronk]

280k*07=19200. Times 20 years gets you to 672k, make some payments along the way and its lower obviously

kronk youd pay tax on 450k in your scenario

Thanks. I'm curious how they calculate assets put into something like property. It's not like they have an assessor cruising around. Do I have to put a value on property I own during each tax season (never owned a home before)?

Final question, I assume money put into a 401K isn't considered an asset for the purposes of loan forgiveness. Am I wrong?

[A. Nony Mouse]

You pay property taxes on your home each year; your local entity (county or whatever) assesses the value.

[Kronk]

You pay property taxes on your home each year; your local entity (county or whatever) assesses the value.

#thingsa26yearoldshouldknow

thanks

[Johann]

just gotta pull the Fat duck and reincorporate in barbados. realistically, you should TRUST that you won't have to pay tax on all that. build assets.

[A. Nony Mouse]

You pay property taxes on your home each year; your local entity (county or whatever) assesses the value.

#thingsa26yearoldshouldknow

thanks

don't worry, it's been long enough since I owned a home had a mortgage that I had to google to make sure I remembered correctly.

[Tiago Splitter]

Final question, I assume money put into a 401K isn't considered an asset for the purposes of loan forgiveness. Am I wrong?

Looks like it. the irs insolvency worksheets has a space for that stuff under assets

http://www.irs.gov/pub/irs-pdf/p4681.pdf