While married life is a happy one (I say this solely based on my friends’ social media postings), sometimes student loans can be the homewrecker. Student loans have been blamed for people delaying marriages and starting families. It also complicates financial and tax planning for couples. Finally, it might be the deciding factor in a divorce. So let’s look at a few events in a married couple’s life and how student loans can affect them.
Before getting married
As I mentioned in a previous article, a large student loan should not be a barrier to marriage. A marriage can last even if one or both spouses have large student loan debts. Before getting married, each person should disclose their total student loan debt to the other and have a plan to manage and ultimately pay off or settle the loan.
Refinancing their loans while married
For some married couples, as their joint income increases, it might make them think differently about what to do with their debt. For example, a couple on an income-based repayment plan might want to pay the balance in full in 10 years rather than pay for 20 or 25 years until forgiveness if only a small amount of the debt will be forgiven.
In this case, the couple might want to either consolidate their loans or combine them into a private loan with a lower interest rate. But some banks will agree only if both spouses’ names are on the loan or if one spouse co-signs the other.
Personally, I would run from any lender that demanded this. If there is one thing I don’t want to share with the person I love, it is my massive debt.
For those who live in community property states, refinancing your pre-marriage student loan debt during marriage could convert it into a community debt where each spouse will be liable for one-half of the debt. In most community property states, any debt incurred during marriage is considered a community debt while any debt incurred outside of marriage is a separate property debt.
When a student loan is refinanced during marriage, some states view this as a community debt because community funds were being used to pay off older separate property debt. But other states do not see a refinance as a conversion into community property so long as only one spouse refinances his or her own debt without the other spouse’s involvement.
I think the latter is the better way to go. Otherwise, one spouse might be tempted to secretly refinance the loan in order to convert their separate property loan into a community property loan.
Divorce
Every state has its own rules and nuances on how student loans are divided (or not) between spouses in a divorce. While I am sure an entire column can be devoted to this topic alone, for now I suggest checking with your state’s rules to see when a spouse must pay the other’s student loans in a divorce.
The law may not be black and white. For example, in California, student loans generally must be paid by the party who received the education unless there is a written agreement to the contrary. But a court can say otherwise it if it thinks the result will be unjust. In this situation, the court looks at whether the community substantially benefitted from the training or the loan, whether the other spouse has a similar education, and whether the education or training resulted in gainful employment which reduced the need for support. For example, if student loan money was used to pay rent in a fancy apartment for the formerly married couple, the court is likely to find that the community benefitted from the loan proceeds.
Also, a couple where one or both spouses are on an IBR plan may be tempted to divorce and structure their dissolution in a way that minimizes loan payments and the cancellation of debt income tax described below. A few couples might divorce on paper while continuing to live as spouses. But most couples might have troubled marriages and the possibility of avoiding a huge income tax bill can be the incentive they need to divorce instead of staying together.
Tax planning
Tax planning for those on income-based repayment plans takes a different turn when student loans are involved.
Couples may need to determine whether it is financially efficient to file jointly or separately. An easy way to calculate a monthly repayment plan through an income-based repayment program is to look at the debtor’s adjusted gross income (AGI) on their tax returns. Most income based repayment programs look at only the debtor’s AGI when filing single or married filing separately. But when they file jointly, the monthly payment looks the joint AGI which can result in a higher monthly payment.
As a result, some married couples will file separately in order to pay lower student loan taxes. The problem is that in most cases, filing separately will result in higher taxes because they are taxed at a different bracket and lose certain deductions and credits — like the student loan interest deduction and the child tax credit, to name a few.
And of course, when the loans are forgiven, the forgiven amount is includible as taxable income — otherwise known as the infamous “tax bomb.” In a few years, we will see all kinds of techniques taxpayers can use to avoid or minimize the effects of the income tax bomb.
The most common way to minimize cancellation of debt income is to show insolvency. This is where the taxpayers show that their liabilities exceed their assets. Business structures will be customized to minimize income to the debtor spouse. Estate plans may include early gifting of assets. Divorces may be structured where the debtor spouse gets little to no assets. All of this could defuse the tax bomb.
Being married with student loans can be done with the proper planning before and during the marriage. But in case it does not work out at some point, at least it might give an opportunity to avoid a huge income tax debt.
If you live in Southern California and want to know more about some of the tax strategies I mentioned above, I am giving a presentation before the Pasadena Section of CalCPA on Monday, October 28, 2019 at 12 p.m. Click here for more details and registration information. This presentation may be eligible for CLE credit. But most importantly, the venue has fantastic Mexican food.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at sachimalbe@excite.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.