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What Biden's student loan forgiveness would mean for your taxes

A tax expert weighs in on how Biden's student loan forgiveness plan would affect borrowers' taxes.

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Since President Joe Biden's first day in office, federal student loan borrowers have been eager to see if and when he will follow through on his campaign promise to cancel $10,000 of loans per borrower as part of his Emergency Action Plan amid the ongoing pandemic.

Student loan forgiveness would ease the financial burden that 42 million borrowers have long faced. And as Democrats like Chuck Schumer and Elizabeth Warren continue to urge President Biden to take swift action — even increasing the forgiveness to $50,000 per federal student loan borrower — there's a chance borrowers may find relief in the coming months.

Below, we break down more on where Biden's student loan forgiveness currently stands and the implications it would have on borrowers' taxes.

Where Biden's student loan forgiveness currently stands

Biden's $1.9 trillion American Rescue Plan unveiled in late January didn't mention canceling student debt, yet his administration has since said that he still supports the forgiveness and is discussing next steps.

In a Feb. 4 tweet by White House press secretary Jen Psaki, she said, "The President continues to support the cancelling of student debt to bring relief to students and families. Our team is reviewing whether there are any steps he can take through executive action and he would welcome the opportunity to sign a bill sent to him by Congress."

With Democratic lawmakers as recent as last week continuing to ramp up the pressure on Biden to immediately cancel student loan debt amid an unstable economy, this could mean borrowers may see action taken or a decision made within his first 100 days as president as he focuses on the nation's economic recovery.

What Biden's student loan forgiveness would mean for borrowers' taxes

While the cancellation of student debt is still unknown, it's important for borrowers to know ahead of time what tax implications come with any sort of loan forgiveness.

"If the government takes the next step and cancels some or all student loans, then the loan forgiveness, in many cases, will be taxable," Steven Rossman, CPA and shareholder at Drucker & Scaccetti, a Philadelphia-based accounting firm focusing on taxation, tells CNBC Select. "Generally, when a debt is forgiven, student loans or otherwise, the amount forgiven represents taxable income in the year it is written off."

Rossman helps us break down a hypothetical example to show how federal student loan forgiveness of $10,000 would be taxed:

As a federal student loan borrower, you have $10,000 of your loans canceled in 2021. This means that $10,000 would be added to your taxable income, under what's called "Cancellation of Debt (COD)" income, and you would presumably receive a Form 1099-C for 2021 as documentation.

Then, when you go to file your 2021 tax return (in April of 2022), you will have $10,000 to report as COD income. If you are, for example, in the 20% federal tax bracket, this will result in an additional tax of $2,000 ($10,000 x 20%), which will be due in April of 2022 when 2021 taxes are filed. (Tax rates will vary by individual.)

"The good news is that the borrower doesn't have to pay back $10,000, but the bad news is that they would owe $2,000 for taxes," Rossman says.

When student loan forgiveness is tax-free

There are certain exceptions that apply as to whether or not student loan forgiveness can be taxed. Finaid.org says that the forgiveness may be excluded from taxable income if it is contingent upon the borrower working for a specific period of time in a certain profession, such as with Public Service Loan Forgiveness (PSLF). Additional exceptions to taxable canceled debt can be found on the IRS website.

The unprecedented circumstance of the pandemic, however, may mean that student loan borrowers could see additional exceptions set in place, Rossman speculates.

"As we've seen from loan forgiveness in the Paycheck Protection Program (PPP), the loans forgiven under the PPP are not taxable to business owners, if the loans are used for eligible business expenses," he says. "Perhaps this will set precedent for the taxability of student loans that are forgiven, but as far as I know, no politicians are talking about student loan forgiveness being tax-free."

How to prepare now for potential student loan forgiveness

If you have federal student loans that could be forgiven, plan ahead by making sure you have money set aside for any big tax bills come April 2022.

One option is to start putting money into a high-yield savings account that earns interest. The Varo Savings Account offers an above-average APY, as well as two programs that automatically transfer money from your Varo bank account to your savings account: Save Your Pay, which transfers a percentage of your paycheck into your savings, and Save Your Change, which rounds up your checking account transactions to the nearest dollar and transfers the difference to your savings.

Just putting aside $20 per week can get you to $1,000 in a year, which may come in handy if you owe the IRS.

Bottom line

Student loan forgiveness in 2021 will likely increase your taxable income, so it's best to prepare ahead if you think Biden's plans will apply to you. Keep an eye out as Congress negotiates additional coronavirus relief measures in the coming months, and start saving a little bit every paycheck now so that you're ready when taxes are due.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the CNBC Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.