Education Tax Benefits (page 4)

This section describes several tax benefits for educational expenses. Other related programs, such as section 529 plans and Coverdell Education Savings Accounts, can be found in the Saving for College section. The page concerning Education Tax Benefit Coordination is also helpful when you're trying to maximize your benefits from the various education tax benefits. Additional information on these education tax benefits can be found in IRS Publication 970, Tax Benefits for Education (PDF). See also IRS Form 8863 for more information on the Hope Scholarship and Lifetime Learning tax credits.

Hope Scholarship

The Hope Scholarship provides a $1,650 tax credit per student per year for higher education expenses during the first two years of post-secondary education. (The amount increased in 2006. Previously it was up to $1,500. The amount of the Hope Scholarship is increased to $3,300 for Gulf Opportunity Zone Students.) The amount of the credit is 100% of the first $1,100 of qualified tuition and related expenses per student and 50% of the second $1,100 of qualified tuition and related expenses. The taxpayer must list the student as an exemption on their income tax return and the expenses must have been paid by the taxpayer or by the student. (Any qualified tuition and related expenses paid by the dependent are treated as though they were paid by the taxpayer, per 26 CFR 25A(g)(3).) Scholarships and financial aid do not count as qualified tuition and related expenses paid by the taxpayer. Only out-of-pocket expenses count. Gifts, bequests and inheritances do count as though paid by the taxpayer.

• The credit is allowed only for the first two tax years of higher education expenses per student. Typically the first tax year will correspond to the fall of the student's freshman year in college, and the second tax year will correspond to the spring of the freshman year and the fall of the sophomore year.
• The student must be enrolled at least half time for at least one academic period that begins during the taxable year.
• The credit is allowed only for the first two years of postsecondary education. It cannot be used if the student already has two years of post-secondary education.
• The credit will be denied for a student convicted of a felony drug offense.
• If the family has multiple students that meet the requirements, then multiple Hope Scholarship Credits may be claimed.
• The credit applies to expenses paid after December 31, 1997.
• The maximum credit per student per year is $1,650.
• You cannot use the Hope Scholarship with the Lifetime Learning tax credit for the same student in the same year, but you can use them for different students' educational expenses in the same year.
• You cannot use the Hope Scholarship and the Tuition & Fees Deduction for the same student in the same year.
• The Hope Scholarship can be used in conjunction with other tax benefits, provided that different education expenses form the basis for each benefit.
• There is an income phaseout for incomes from $45,000 to $55,000 (single filers) and $90,000 to $110,000 (married filing jointly). (These are the 2006 phaseouts. The phaseouts are indexed for inflation.) You cannot use the credit if you are married filing separate returns.

Lifetime Learning Tax Credit

The Lifetime Learning Tax Credit provides a tax credit of up to $2,000 per taxpayer for education expenses. The amount of the credit is equal to 20% of the first $5,000 of qualified tuition and related expenses paid by the taxpayer. Starting in 2003, the $5,000 limit was increased to $10,000. Thus the credit is up to $1,000 through the year 2002 and $2,000 thereafter. (In 2006 the maximum lifetime learning tax credit increased to $4,000 and 40% for gulf opportunity zone students.)

Note that the Lifetime Learning credit does not vary according to the number of students. This is in contrast with the Hope Scholarship, which is based on the number of eligible students in the household. This means that if you have multiple children in school at the same time and your tuition bills total more than $10,000, you only get the credit for the first $10,000 paid. You don't get another credit for each additional child. The credit is relative to the total amount of tuition paid, irrespective of the number of children in school.

Qualified tuition and related expenses includes expenses for any course of instruction at an eligible educational institution to acquire or improve job skills. This means that the credit may be used for part-time study, not just students enrolled at least half-time in a degre program.

Unlike the Hope Scholarship, the Lifetime Learning tax credit may be claimed for an unlimited number of years.

The credit applies to expenses paid after June 30, 1998.

The Lifetime Learning tax credit has the same income phaseouts and coordination restrictions as the Hope Scholarship.

Deduction for Student Loan Interest

You can deduct up to $2,500 in student loan interest. The deduction is taken as an adjustment to income, so you can take the deduction even if you don't itemize deductions on Schedule A of your 1040. The deduction is phased out for taxpayers with adjusted gross incomes of $50,000 to $65,000 (single filers) and $105,000 to $135,000 (married filing jointly). (These are 2006 income phaseouts.) Taxpayers who are married but file separate returns are not eligible.

The requirements are as follows:

• The interest must be paid on a qualified education loan for you, your spouse, or someone who was your dependent when the money was borrowed.
• You must not be claimed as an exemption on someone else's tax return.
• The person for whom the expenses were incurred must have been enrolled at least half-time in a degree program.
• You cannot take the deduction when the expenses were paid using certain tax-free education benefits, such as employer education assistance, tax-free withdrawals from a Coverdell Education Savings Account, US savings bond interest, veterans educational assistance benefits, and certain scholarships.
• You cannot double-dip, meaning that if the interest is deductible elsewhere on the return (e.g., home mortgage interest), you cannot also deduct it as student loan interest.
• Eligible education expenses include tuition, fees, room and board, books, supplies, and equipment, transportation expenses, and other necessary expenses (as included in the school's student budget).

Parents who do not qualify because of the income phaseouts should consider having their child borrow the funds. Not only does the Stafford Loan have a lower interest rate than the PLUS loan, but the student is less likely to exceed the income phaseouts.

According to regulations published by the IRS on May 7, 2004, education loan origination fees and capitalized interest qualify as deductible education loan interest. The amounts are amortized over the term of the loan (i.e., divide the capitalized interest by the number of years of the loan). Lenders will start reporting origination fees and capitalized interest for loans made on or after September 1, 2004. Students and parents can claim the deductions for past years by filing amended income tax returns.

The regulations also clarify that only the person legally obligated to repay the education loan may take the interest deduction. If someone else makes payments on a student's education loans, the student gets to take the deduction, not the other individual. For example, if a grandparent helps the student out with a few loan payments, the student takes the deduction, not the grandparent. These payments are treated as though they were first paid to the student, and then by the student to the lender.

Note that the borrower must have been legally obligated to make payments under the terms of the loan. This means that if the borrower voluntarily makes payments of interest during a period when such payments are not required, such as during a forbearance, deferment or grace period, that interest is not deductible. However, if the interest is required as part of the forbearance or deferment agreement, then the interest is deductible.

A qualified education loan is defined as a debt borrowed solely to pay higher education expenses. Mixed-use loans do not qualify. This means that if the borrower refinances their education loans and receives cash out, interest on the new loan is no longer deductible. However, if the excess cash is only used to pay for higher education expenses, the interest on the new loan remains deductible.

Interest on private education loans qualifies, provided that the higher education expenses are attributable to a particular academic period and the disbursement used to pay for those expenses occured during the academic period or a 90-day window at the start and end of the academic period. Education loans do not need to be federally guaranteed to qualify. The debt, however, may not be owed to anybody who is related to the borrower.