Student Loan Help From Family Could Mean Extra Taxes

Michael Lux Blog, Mailbag, Student Loans 0 Comments

The week we received an email from Steve with an interesting tax question.  Steve is about to be the lucky recipient of a bunch of money from his family.  He intends to use this money to pay down his student loans.  Unfortunately, this can potentially trigger a gift tax bill from the IRS.  The good news is that there are ways of avoiding this taxation.

Steve writes:

I have $30,000 left on school loans I’ve been paying on for years (no late payments).  My family wants to pay them off for me so its done with.  What is the best way to do this? Do I have them gift me the money, then me pay it off? Or have them directly pay it off? What does each option have to do with taxes when the time comes?

Thank you for the help.

Steve

Student Loan Payments and the Gift Tax

Under federal tax law, large sums of money given to another individual are subject to a gift tax.  In 2017 the gift tax has to be paid for gifts over $14,000.  There are gift tax exceptions for gifts to a spouse, medical payments, and tuition payments.  Unfortunately, student loan payments do not fall within a gift tax exception.

The person making the gift is usually the party responsible for paying the gift tax.

It is also worth pointing out that whether the money goes directly or indirectly to the beneficiary, the tax is still incurred.  This means that whether Steve’s family gives him the money directly or just pays off his student loans, they still potentially have to pay the gift tax.

For more details on gift tax basis, be sure to check out the IRS Frequently Asked Questions on Gift Taxes.  More detailed instructions on the gift tax can also be found on IRS Publication 559.

The good news is there are a few ways in which Steve and his family can potentially avoid having to pay any gift tax.

Avoiding Gift Taxes on Student Loan Payments

One of the most common ways to avoid gift taxes is to spread the money out over several years.  Steve’s family could give him $14,000 in 2017 and then another $14,000 in 2018 without triggering any gift tax.

The gift tax also treats spouses as individuals.  That means Steve’s mom and dad could both contribute $14,000 in 2017 without having to pay any taxes.  If Steve received $14,000 from his mom, dad, grandpa, and grandma, he would get a total of $56,000 without any family member having to pay a gift tax.

Student Loan Exception to the Gift Tax

There is one scenario in which a student loan payment from the family may not be subject to the gift tax.

According to the Wall Street Journal and Time, payments made by a co-signer towards a student loan are not subject to the gift tax.  For example, if Steve’s mom co-signed his student loans, she is legally responsible for the debt just like Steve.  As such, if she paid off a student loan that she was the cosigner on, she wouldn’t have to pay a gift tax on the payment, even if it is above $14,000.

Paying More than $14,000 on Student Loans

Suppose the full $30,000 from Steve’s email is coming from a wealthy uncle, and none of the previous strategies we outlined will work.  Even in this circumstance, the gift tax can still be avoided.

The $14,000 limit is the yearly limit on gifts.  However, there is also a lifetime limit, commonly referred to as the unified credit.  As of 2017, the unified credit is over five million dollars.  That means Steve’s uncle can give him the full $14,000, and then subtract the remaining $16,000 from his unified credit.  However, this does require filing a special return.  More on the unified credit can be found on TurboTax and the IRS page on the Estate Tax.

In other words, it is possible for student loans to be paid off by family members (or non-relatives) without paying any gift tax… as long as you file the proper paperwork.

Bottom Line

Large contributions towards student loan debt are subject to the federal gift tax.  However, there are a number of ways in which this tax can be avoided.  Whether you are the one giving the money or receiving it, make sure to get familiar with these concepts.  Once you have your mind wrapped around the basics, be sure to discuss your different options with an accountant to ensure you don’t violate any IRS rules.

Finally, keep in mind that this article just focused on federal tax issues.  Your state may have additional taxes that could be triggered by a student loan gift.