The Fuse

Hidden Costs: How Forgiveness of Student Debt Could Reduce Vehicle Ownership

by Hart Schwartz | April 17, 2018

The budget of millions of consumers could be severely constrained from taxation of student debt forgiveness, pressuring many households to forego buying new vehicles.

A previous article in The Fuse showed the unprecedented rate at which student loans have expanded in recent years, nearing the one-and-a-half trillion dollar mark in outstanding debt in 2018, a scale that may strain household balance sheets and reduce vehicle ownership in the United States. In recent years, legislation has provided possible relief for borrowers, in the form of loan forgiveness after 20 years (240 months) of reduced payments, but surprisingly, loan forgiveness can actually worsen, not improve, household balance sheets. Lenders (Department of Education (DOE) all student loans) must use Form 1099-C, “Cancellation of Debt,” to report “forgiven” debt to the IRS. In turn, the “forgiven” borrower needs to claim the debt as taxable unearned income in the year of forgiveness. Combined with an interest debt trap which causes ballooning student loan balances, the 1099-C could trigger an enormous tax liability at the moment of supposed loan forgiveness, on the order of anywhere from $10,000 to over $100,000 immediately due.

With millions of student loans set to be forgiven starting in the early 2030s, a ticking demographic time bomb is gathering. This time bomb may start exploding just as today’s students are becoming tomorrow’s parents of students, triggering a multi-generational debt cycle because parents paying taxes on loans may be unable to afford their childrens’ higher education. At this future moment, the budget of millions of consumers could be severely constrained, pressuring many households to forego one or more vehicles and to drive existing vehicles less often to save on fuel costs.

According to the American Automobile Association (AAA), the average cost for an American to own a new vehicle in 2017 was $8,469 annually ($706 per month).

According to the American Automobile Association (AAA), the average cost for an American to own a new vehicle in 2017 was $8,469 annually ($706 per month). This figure includes finance costs; fuel; maintenance, repair, and tires; license, registration, and taxes; and depreciation. There is a long list of necessities involved in owning a vehicle, and if enough of the ability to pay for several of these line items were impaired by the “student debt tax bomb,” the costs of vehicle ownership relative to available household funds could escalate beyond affordability. (Assuming that the “student debt tax bomb” will detonate as predicted in the 2030s, amid roughly comparable vehicle costs to today.)

How 1099-C reporting works: Pass the debt from one federal agency to another

Under current law, cancelled debts of many kinds, including student loan debt, must be reported to the IRS, by the lender, on a 1099-C in the year of forgiveness. Another copy of the 1099-C is sent to the taxpayer, in this case the student loan borrower, who will then need to claim that loan on that year’s 1040 income tax form as “unearned income.” Since most federal student loans are directly issued by the DOE, this means that the agency, in the year of forgiveness, will issue a 1099-C simultaneously to the IRS and to the “forgiven” borrower. The borrower will then need to claim that loan on that year’s 1040 tax form as “unearned income,” to be taxed at federal rates anchored around 25 or 30 percent.

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Tax strategies: The insolvency exclusion

In fairness, it should be noted that tax strategies exist for softening the blow of the 1099-C. Most notably, the “insolvency exclusion” of IRS Form 982 allows taxpayers to reduce taxable income by the amount by which that taxpayer’s liabilities outnumber assets (including the student loan itself in the tally). This has been explained very clearly by Los Angeles-based attorney Steven Chung, on the website lawyerist.com. For example, a person with $150,000 in assets and—immediately before the cancellation of debt—$300,000 in liabilities would have a net worth of negative $150,000, and could thus omit $150,000 of forgiven debt from income.

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The interest debt trap—ballooning loan balances

However, the “insolvency exclusion” is offset by the harshness of the interest debt trap. Borrowers on reduced-payment plans often find that interest accumulates faster than payments. An original loan principal amount of $100,000 can add a net amount of $10,000 in interest charges per year (accumulated monthly interest minus monthly payments). At this rate, the original $100,000 in debt (the cost of a two-year graduate program) would become $300,000 in debt by the time, 20 years later, it is ready for forgiveness and taxation. Given prevailing rates of interest and tuition, the interest-and-tax trap is a common process which will predictably occur for millions of borrowers after 20 years of fully-compliant monthly payments.

Perverse incentives against ownership of assets

The impact of taxation of student debt forgiveness for household budgets is clear. Major proportions of the household budget could become devoted to non-vehicle costs, thus crowding out money previously devoted to the vehicle costs listed by AAA in annual cost of ownership, such as finance; fuel; maintenance, repair, and tires; license, registration, and taxes; or depreciation. People may choose to forego vehicle purchases, or give up one or more household vehicles, in the years following loan forgiveness, during which they need to pay the tax bills. The IRS offers installment payments of up to 72 months, so this situation of cramped budgets could last for up to six years.

Middle-class bears the brunt

Middle-class families could find themselves severely cash-flow-constrained.

Particularly hard-hit would be upper middle-class Americans who hold a significant amount of assets (perhaps between $200,000 to $750,000 of household assets) but who are not millionaires. These Americans would most likely not benefit from the insolvency exclusion and could face the need to declare the entire $100,000 to $300,000 loan balance as unearned income, thus triggering severe, immediate, and heavy taxation in the year of forgiveness. These households, which often have served as engines of consumption driving the U.S. economy, could find themselves severely cash-flow-constrained, without funds to purchase an extra vehicle or maintain an existing vehicle.

The demographic time bomb: Self-reinforcing across generations?

There could end up being a multi-generational middle-class debt cycle if college costs continue soaring.

However, the most serious issue is a ticking demographic time bomb, which could set off a multi-generational middle-class debt cycle if college costs continue soaring. Someone who graduates from a degree at age 26, makes qualified payments for 20 years, and has the outstanding balance forgiven at age 46, could be facing a giant loan forgiveness tax bill right at the moment at which this person’s children will be entering college. The very same loan-trap which snared the parent could be self-reinforcing, snagging the children, too, hitting the same family in two generations. A middle-class family experiencing such a situation may need to economize on various items of the household budget, finding one of its automobiles to be an unnecessary encumbrance.

Moving toward reality in the 2030s and 2040s

The 2030s and 2040s could see wave after wave of families hit by massive tax bills from student loan forgiveness.

The massive rise in student loan burdens has only begun in the past decade to fifteen years, whereas it takes at minimum 20 years after completion of a degree for the above tax-and-debt trap to take effect. Therefore, the 2030s and 2040s could see wave after wave of families hit by massive tax bills. For instance, a student who entered a four-year college in 2010 at age 18, and graduated in 2014 at age 22, would face the forgiveness trap in 2034, at age 42. A student entering a professional school (dentistry, psychology, law, medicine, etc.), in 2018, at age 25, graduating between 2021 and 2023 at age 28 to 30, may face the forgiveness trap in 2041 to 2043, at age 48 to 50.

Will there be legislative relief?

At the current time, a legislative remedy appears remote, although it should be noted that major student loan income-adjusted payment relief was passed by Congress as recently as 2011. If student loans become a drag on the economy, the situation may receive major and targeted legislative relief just in time to avoid widespread problems with this trap. There’s also the possibility of the Treasury Department taking action to provide relief. Georgetown University law professor John R. Brooks has argued in favor of steps by the Treasury Department, without need for Congressional action, in a September 2016 article in the journal Tax Notes.

Drag on economic growth

If current trends continue unabated, there is likely to be a drag on consumption from the enormous growth of student loans, slowly progressing toward millions of households undergoing painful forgive-and-tax scenarios triggered by the filing of a dreaded 1099-C at the end of a 240-month course of reduced-payment loan repayments. Given the increasing necessity of a bachelor’s degree in today’s economy, let alone a master’s or professional degree, as well as continually rising tuition costs, it appears that “something’s got to give.” But it’s not clear what, how, or when. Another recent Fuse article (see here) analyzed sweeping changes in paradigms at 50-year intervals throughout the history of American transportation. Will higher education, and ways of financing it, similarly experience sweeping paradigm changes over the next half-century?

The student loan predicament should be factored into future forecasts of how much of the American household budget will be allocated to vehicle ownership and fuel consumption in the coming decades.

For those who study petroleum dependence and fuel consumption, consumer economics has long been a staple component of analysis. The slow but potent “ticking time bomb” of the student loan predicament, as embodied in the paradoxical “gift” of the 1099-C, is a significant variable that should be factored into future forecasts of how much of the American household budget will be allocated to vehicle ownership and fuel consumption in the coming decades.

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