Indiana is one of seven states planning to tax most student debt forgiveness as income. But that decision predates the Biden administration’s announcement by a year, and it won’t apply to all borrowers.
In 2021, the U.S. Senate laid the groundwork for federal student debt relief by passing the Student Loan Relief Act, which would make student loan forgiveness tax free. The Indiana state legislature voted not to conform with that law. IU Law Professor David Gamage explained that states have the ability to choose which parts of the federal tax code to apply for state taxing purposes.
“In 2021, Congress passed a new tax code provision making qualifying student loan forgiveness not taxable,” Gamage said. “Indiana then chose to conform to most of federal law, but explicitly not to conform to this provision.”
In spite of that, the Indiana legislature’s decision only applies to income that would be considered taxable before the Student Loan Relief Act. Gamage said there’s one solid doctrine that would exempt some borrowers from taxation and several less-solid doctrines that could set the ground for a broader push for tax exemption.
“The clearest-cut doctrine is the Insolvency Provision,” Gamage said. “For any Indiana resident whose total debt exceeds total assets - and that’s true after the student loan forgiveness - the insolvency provision should apply and make the loan forgiveness not taxable for Indiana state tax purposes.”
That provision would protect some of the most indebted Hoosiers, but what about the rest? Gamage said while the state legislature’s decision on taxing debt relief likely couldn’t be challenged in court, borrowers could make an argument for expanding exemptions.
One of these is a legal concept known as the General Welfare Doctrine, which excludes payments made under social benefit programs on account of need from being taxed as income.
If borrowers decided to make this appeal, Gamage said, it could lead to a tricky legal battle with the Department of Revenue, “because the law is somewhat murky and inconclusive.”
The second way borrowers might contest taxation is to invoke the Disputed Debt Doctrine.
“If an Indiana resident who has loans forgiven has a good-faith dispute about the value of their debt or the value of what they received from their debt in the first place, in some circumstances courts have ruled that a settlement of portions of the debt is a ‘renegotiation’ of the amount of loan value that should be viewed as taken out in the first place for tax purposes,” Gamage explained.
There’s some precedent for referring to this doctrine for student loan forgiveness, as in the case of students who were defrauded by for-profit colleges. By a certain interpretation, Biden’s loan forgiveness program could be considered recognition that student debt is overvalued.
“Part of the thought behind the federal student loan forgiveness is that the student loan programs haven’t been working well and should be renegotiated,” Gamage said. “But this is novel legal grounds.”
Indiana residents who had debt forgiven could stand to lose hundreds in state income taxes under the current state tax code. Pandemic-era Paycheck Prevention Program loans to businesses which were forgiven last year have not been taxed, despite sometimes tallying as high as $10 million per borrower.
