Updated September 9, 2022 at 4:07 PM ET

When federal student loan borrowers take a breath from celebrating the cancelation of some or all of their federal student loans, millions of them could be in for a nasty surprise:

While President Biden's sweeping student debt relief won't be subject to federal income tax, in seven states borrowers may have to pay state income tax on all those canceled loans.

Before 2021, student debt cancelation was generally considered a form of income, and therefore taxable both at the federal and usually state level. But in March of 2021, the American Rescue Plan changed that, at least temporarily: Until the end of 2025, Congress said, the U.S. government will not consider canceled student loan debts to be taxable income.

Now that the Biden administration has unveiled its sweeping new debt cancelation plan, this federal exemption is a really big deal. That's because most places follow the federal government's lead when it comes to income tax.

"The majority of states that have an income tax essentially say, 'Whatever the federal government says is gross income, we say the same thing,' " explains John Brooks, a Fordham University professor who studies both tax policy and student loan law.

But seven states are out of step with federal tax policy and have either said they will tax debt relief or still have policies that could require it, barring a change in state law.

States where borrowers may be taxed for loan cancellation

1. North Carolina

Like most states, North Carolina conforms to federal tax law. What's interesting here is that the state decided, in spite of Congress, to tax student debt relief.

In a statement, the North Carolina Department of Revenue tells NPR the state's General Assembly chose not to adopt the federal student debt tax exemption. "The Department is monitoring any further enactments by the General Assembly that could change the taxability of student loan forgiveness in North Carolina," a spokesperson says.

But for now, it's taxable. And the Assembly has given no indication it will change that.

2. Indiana

Like North Carolina, Indiana tends to follow federal tax policy, but has similarly chosen to break with Congress on this. Tax officials there have confirmed (to the AP) that residents will be expected to list any debt relief they receive under taxable income.

3. Mississippi

Now things get more complicated. Unlike most states, Mississippi doesn't follow federal tax policy, so the changes in the American Rescue Plan don't mean much there. That's no guarantee they will ultimately tax debt relief; it just means that, right now, there's nothing on the state's books to exempt canceled loans.

As such, Mississippi's Department of Revenue has reportedly confirmed that under current state law, student debt relief is taxable.

4. Arkansas

Like Mississippi, Arkansas' tax policies don't follow federal policy, so, again, there's no obvious exemption on the books there to protect debt relief from being taxed. But... Arkansas has not yet said it will tax these canceled loans.

In an email to NPR, a spokesperson for the Arkansas Department of Finance and Administration says, "Our Department is currently reviewing whether debt forgiveness in this scenario is subject to state income tax in Arkansas. If we determine this is indeed subject to state income tax, legislative action would be required to change/exempt it. The next session of the Arkansas General Assembly is scheduled to begin in early 2023."

5. Minnesota

Now the murky gets even murkier. While most states mirror federal tax policy, some are simply out-of-date, like Minnesota. It conforms to federal policy that pre-dates the American Rescue Plan, going back to 2018, when debt relief was still considered taxable.

The fact that Minnesota could technically tax debt relief is not an intentional response to the news, says Jared Walczak of the Tax Foundation. Walczak advises state leaders on tax policy and has been paying close attention to this income tax conundrum.

"They did not go through with this saying, 'Well, if President Biden makes this policy enactment, we are going to tax this.' This is just the continuation of existing law. It's where pretty much every state would have been a year ago."

But most states have updated their policies, Walczak says. Minnesota and a handful of other states, "because of the quirks of their tax codes, have not. That is something they could potentially fix."

Minnesota's Democratic governor tried to fix it, introducing a tax bill during the last legislative session that would have brought the state up-to-date, "however, that legislation was not passed so Minnesota is currently out of conformity with federal law in that area," a spokesperson for the Minnesota Department of Revenue writes in an email to NPR.

"If the state does not conform to this federal law, then Minnesota taxpayers who have their student debt discharged will have to add back this amount for Minnesota income tax purposes."

6. Wisconsin

Like Minnesota, Wisconsin also conforms to outdated federal tax policy, in this case from 2020, just a few months before the ARPA exempted student debt relief.

"It hasn't updated it since then," says Brooks at Fordham University, "which is not to say that they don't want to. It just doesn't seem to be an immediate priority right now in their legislative calendar." Brooks says that's in part because the federal debt relief action is still brand new.

Both Minnesota and Wisconsin could still update their state tax policies and choose to exempt student debt relief. Though any changes would need to happen by early 2023, before tax season, or last-minute tweaks could lead to widespread confusion.

7. California

Believe it or not, it's possible this Democratic stronghold could find itself having to tax millions of Californians who qualify for Biden's debt relief plan – because the state conforms to federal tax policy from 2015, according to the Tax Foundation. It does have tax exclusions on the books for some specific kinds of debt relief, like loans canceled through an income-based repayment plan, but, depending on whom you ask, it's either unclear or unlikely that those can be applied to Biden's recent announcement.

In an email to NPR, a spokesperson for the California Franchise Tax Board says they can't yet say if debt relief in California will be taxable because they need more information from the U.S. Department of Education. "We are saying the loan forgiveness (i.e., cancellation of indebtedness) would be taxable in California UNLESS this federal student loan debt is repaid or canceled pursuant to 1098e of Title 20 of the United States Code."

Secret decoder ring: That section of the tax code refers to debts discharged through income-based repayment plans. And, says Walczak, "I can't imagine any scenario in which [debt under the Biden plan] would be forgiven under those sections."

In other words, California leaders will likely need to take some additional action if they don't want the state taxing millions of student loan borrowers there. And action seems highly likely, with leaders of the state legislature tweeting on Friday, "Rest assured, one way or another, California will not tax the federal student debt relief."

How much income tax borrowers may have to pay

President Biden's loan forgiveness plan would cancel up to $10,000 in debt for individuals who earn less than $125,000 a year, or less than $250,000 a year for couples; and it would cancel up to $20,000 for borrowers who received a Pell Grant in college and meet those income requirements.

Assuming a hypothetical state income tax rate of 5%, a borrower who receives $10,000 in debt cancellation would be on the hook for $500 in state income tax, and a borrower who receives the Pell-eligible $20,000 in relief could have to pay as much as $1,000 to the state.

That may be a high bar for some borrowers. After all, this relief is a debt reset; it's not a windfall of dollars that can then be used to pay off an unexpected tax liability.

"A lot of people anticipate some amount of return and really depend on that at the end of the year to get that money back. So if that gets wiped out, I could see that really disrupting people's financial planning," says Colin Stroud, who lives in Madison, Wisc., and says he qualifies for $10,000 in debt cancellation.

Stroud says, while he can afford the added tax bill if it comes to that, "I just don't understand why you would want to spring this on people. I don't know what is gained by it."

Also, while we're talking about only a handful of states, this is not only a handful of borrowers.

According to federal data from March 2022, almost 8 million federal student loan borrowers live in just these seven states, and the vast majority likely qualify for debt relief.

What borrowers should know about filing their taxes

There's one more reason this muddle could cause yet more confusion come tax time:

The U.S. government has instructed student loan servicing companies not to mail a federal 1099-C form to the millions of borrowers who receive debt relief. This matters, a lot.

In the past, the 1099-C form has been sent not only to borrowers who receive debt relief, notifying them of their tax burden, but also to state tax authorities.

This year, though, because debt relief is not considered taxable income at the federal level, the U.S. government won't be sending out 1099-C forms. That's because if 40 million borrowers receive a form suggesting they owe federal income tax on their debt relief, when they don't, "that would confuse the heck out of a lot of taxpayers," Brooks says.

But without this 1099-C form, it's state tax authorities who'll be confused.

States that want to collect income tax on these canceled student debts won't have a clear way of knowing who got help and who didn't. Tax preparers and tax preparation software can ask borrowers if they received debt relief, and borrowers will have a legal responsibility to answer truthfully, but, without that 1099-C, states will have to rely on the word of borrowers.

Brooks and Walczak both say many borrowers might not report their debt relief as income – not because they're trying to commit fraud but because it simply wouldn't occur to them that it would be taxable, since they're not being asked to pay federal income taxes.

"This is difficult. This is new. People aren't necessarily expecting it, and especially if you don't have documentation being sent to you like you would with just about any other form of debt discharge. It's putting people at a disadvantage," Walczak says.

"If borrowers don't report it," Brooks says, "the state tax agencies don't know that there was cancellation. Everybody just moves on, and it doesn't actually get taxed at the state level in a practical sense, even if the state law says that it should be."

Brooks and Walczak recommend borrowers in these states stay tuned.

It's possible, perhaps even likely, that, given these complications, one or more of these states will update their tax policies in the coming months and follow Congress' lead after all.

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