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Taxmap/pubs/p970-019.htm#TXMP18af5b9b Chapter 4 Student Loan Interest Deduction

Student Loan

Taxmap/pubs/p970-019.htm#TXMP4a3d6583 What's New

Final regulations, issued May 7, 2004, made the following changes to the rules for deducting student loan interest. These changes apply to interest due and paid on qualified student loans after December 31, 1997.

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Longer period allowed for loan disbursement.

The 60-day safe harbor for disbursing loan proceeds used to pay qualified education expenses has been increased to 90 days before and 90 days after the academic period to which the expenses relate. See Reasonable period of time for more information.

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Interest paid by a third party may be deductible.

The person legally obligated to make interest payments on a student loan may be able to deduct interest payments on that loan made by someone else (third party). For more information, see Expenses paid by others.

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If you are affected by either of these changes, you may want to file Form 1040X, Amended U.S. Individual Income Tax Return, to correct a return you have already filed. Generally, you must file your claim for a refund within 3 years after the date you filed your original return or within 2 years after the date you paid the tax, whichever is later.

Introduction

Generally, personal interest you pay, other than certain mortgage interest, is not deductible on your tax return. However, if your modified adjusted gross income (MAGI) is less than $65,000 ($130,000 if filing a joint return) there is a special deduction allowed for paying interest on a student loan (also known as an education loan) used for higher education. For most taxpayers, MAGI is the adjusted gross income as figured on their federal income tax return before subtracting any deduction for student loan interest. This deduction can reduce the amount of your income subject to tax by up to $2,500 in 2004.

The student loan interest deduction is taken as an adjustment to income. This means you can claim this deduction even if you do not itemize deductions on Schedule A (Form 1040).

This chapter explains:

• What type of loan interest you can deduct,
• Whether you can claim the deduction,
• What expenses you must have paid with the student loan,
• Who is an eligible student,
• Who can claim a dependent's expenses,
• How to figure the deduction, and
• How to claim the deduction.

Table 4-1 summarizes the features of the student loan interest deduction.

Taxmap/pubs/p970-019.htm#TXMP11ea46fe Student Loan Interest Defined

Student Loan

Student loan interest is interest you paid during the year on a qualified student loan. It includes both required and voluntary interest payments.

Taxmap/pubs/p970-019.htm#TXMP42fcf839 Qualified Student Loan

Student Loan

This is a loan you took out solely to pay qualified education expenses (defined later) that were:

1. For you, your spouse, or a person who was your dependent when you took out the loan,
2. Paid or incurred within a reasonable period of time before or after you took out the loan, and
3. For education provided during an academic period for an eligible student.

Loans from the following sources are not qualified student loans.

• A related person.
• A qualified employer plan.

Taxmap/pubs/p970-019.htm#TXMP2134ec4f Your dependent.

Generally, your dependent is someone who:

• Receives most of his or her support from you,
• Is either related to you or lives with you, and
• Is a citizen or resident of the United States, Canada, or Mexico.

You can find more information about dependents in Publication 501, Exemptions, Standard Deduction, and Filing Information.

Taxmap/pubs/p970-019.htm#TXMP0819b596 Reasonable period of time.

Qualified education expenses are treated as paid or incurred within a reasonable period of time before or after you take out the loan if they are paid with the proceeds of student loans that are part of a federal postsecondary education loan program.

Even if not paid with the proceeds of that type of loan, the expenses are treated as paid or incurred within a reasonable period of time if both of the following requirements are met.

1. The expenses relate to a specific academic period, and
2. The loan proceeds are disbursed within a period that begins 90 days before the start of that academic period and ends 90 days after the end of that academic period.

If neither of the above situations applies, the reasonable period of time usually is determined based on all the relevant facts and circumstances.

Taxmap/pubs/p970-019.htm#TXMP357d4ce2 Academic period.

An academic period includes a semester, trimester, quarter, or other period of study (such as a summer school session) as reasonably determined by an educational institution. In the case of an educational institution that uses credit hours or clock hours and does not have academic terms, each payment period can be treated as an academic period.

Taxmap/pubs/p970-019.htm#TXMP152ab213 Eligible student.

This is a student who was enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential.

Taxmap/pubs/p970-019.htm#TXMP203cec57 Enrolled at least half-time.

A student was enrolled at least half-time if the student was taking at least half the normal full-time work load for his or her course of study.

The standard for what is half of the normal full-time work load is determined by each eligible educational institution. However, the standard may not be lower than any of those established by the Department of Education under the Higher Education Act of 1965.

Taxmap/pubs/p970-019.htm#TXMP7407982e Related person.

You cannot deduct interest on a loan you get from a related person. Related persons include:

• Your spouse,
• Your brothers and sisters,
• Your half brothers and half sisters,
• Your ancestors (parents, grandparents, etc.),
• Your lineal descendants (children, grandchildren, etc.), and
• Certain corporations, partnerships, trusts, and exempt organizations.

Taxmap/pubs/p970-019.htm#TXMP261dffdc Qualified employer plan.

You cannot deduct interest on a loan made under a qualified employer plan or under a contract purchased under such a plan.

Taxmap/pubs/p970-019.htm#TXMP66363138 Qualified Education Expenses

Qualified Education Expenses

For purposes of the student loan interest deduction, these expenses are the total costs of attending an eligible educational institution, including graduate school. They include amounts paid for the following items.

1. Tuition and fees.
2. Room and board.
3. Books, supplies, and equipment.
4. Other necessary expenses (such as transportation).

The cost of room and board qualifies only to the extent that it is not more than the greater of the following two amounts.

1. The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
2. The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.

Taxmap/pubs/p970-019.htm#TXMP7193c213 Eligible educational institution.

An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited, public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions.

Certain educational institutions located outside the United States also participate in the U.S. Department of Education's Federal Student Aid (FSA) programs. You can find a list of these foreign schools on the Department of Education's website at www.fafsa.ed.gov/index.htm. Click on "Find my school codes." Complete the two items on the first page and click "Next." Follow the instructions to search for a foreign school.

For purposes of the student loan interest deduction, an eligible educational institution also includes an institution conducting an internship or residency program leading to a degree or certificate from an institution of higher education, a hospital, or a health care facility that offers postgraduate training.

An educational institution must meet the above criteria only during the academic period(s) for which the student loan was incurred. The deductibility of interest on the loan is not affected by the institution's subsequent loss of eligibility.

The educational institution should be able to tell you if it is an eligible educational institution.

Taxmap/pubs/p970-019.htm#TXMP0c9c28bd Adjustments to Qualified Education Expenses

Adjustments to Qualified Education Expenses

You must reduce your qualified education expenses by the total amount paid for them with the following tax-free items.

• Employer-provided educational assistance. See chapter 11.
• Tax-free distributions from a Coverdell education savings account (ESA). See chapter 7.
• Tax-free distributions from a qualified tuition program (QTP). See chapter 8.
• U.S. savings bond interest that you exclude from income because it is used to pay qualified education expenses. See chapter 10.
• The tax-free part of scholarships and fellowships. See chapter 1.
• Veterans' educational assistance. See chapter 1.
• Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.

Taxmap/pubs/p970-019.htm#TXMP7b038d71 Include As Interest

Include As Interest

In addition to simple interest on the loan, if all other requirements are met, the items discussed below can be student loan interest.

Taxmap/pubs/p970-019.htm#TXMP035bcae7 Loan origination fee.

In general, this is a one-time fee charged by the lender when a loan is made. To be deductible as interest, a loan origination fee must be for the use of money rather than for property or services (such as commitment fees or processing costs) provided by the lender. A loan origination fee treated as interest accrues over the term of the loan.

If loan origination fees are not included in the amount reported on your Form 1098-E, Student Loan Interest Statement, you can use any reasonable method to allocate the loan origination fees over the term of the loan. The method shown in the example below allocates equal portions of the loan origination fee to each payment required under the terms of the loan. A method that results in the double deduction of the same portion of a loan origination fee would not be reasonable.

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Example.

In August 2002, Bill took out a student loan for $16,000 to pay the tuition for his senior year of college. The lender charged a 3% loan origination fee ($480) that was withheld from the funds Bill received. Because the loan origination fee was not included in his 2004 Form 1098-E, Bill can use any reasonable method to allocate that fee over the term of the loan. Bill's loan is payable in 120 equal monthly payments. He allocates the $480 fee equally over the total number of payments ($480 ÷ 120 months = $4 per month). Bill made 12 payments in 2004, so he paid $48 ($4 × 12) of interest attributable to the loan origination fee. To determine his student loan interest deduction, he will add the $48 to the amount of other interest reported to him on Form 1098-E.

Taxmap/pubs/p970-019.htm#TXMP1afd0ed1 Capitalized interest.

This is unpaid interest on a student loan that is added by the lender to the outstanding principal balance of the loan. Capitalized interest is treated as interest for tax purposes and is deductible as payments of principal are made on the loan.

Taxmap/pubs/p970-019.htm#TXMP428fbc68 Interest on revolving lines of credit.

This interest, which includes interest on credit card debt, is student loan interest if the borrower uses the line of credit (credit card) only to pay qualified education expenses. See Qualified Education Expenses, earlier.

Taxmap/pubs/p970-019.htm#TXMP7cc8dd64 Interest on refinanced student loans.

This includes interest on both:

• Consolidated loans—loans used to refinance more than one student loan of the same borrower, and
• Collapsed loans—two or more loans of the same borrower that are treated by both the lender and the borrower as one loan.

If you refinance a qualified student loan for more than your original loan and you use the additional amount for any purpose other than qualified education expenses, you cannot deduct any interest paid on the refinanced loan.

Taxmap/pubs/p970-019.htm#TXMP123814ec Voluntary interest payments.

These are payments made on a qualified student loan during a period when interest payments are not required, such as when the borrower has been granted a deferment or the loan has not yet entered repayment status.

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Example.

The payments on Roger's student loan were scheduled to begin in June 2003, 6 months after he graduated from college. He began making payments as required. In September 2004, Roger enrolled in graduate school on a full-time basis. He applied for and was granted deferment of his loan payments while in graduate school. Wanting to pay down his student loan as much as possible, he made loan payments in October and November, 2004. Even though these were voluntary (not required) payments, Roger can deduct the interest paid in October and November.

Taxmap/pubs/p970-019.htm#TXMP68100fd1 Allocating Payments Between Interest and Principal

Allocating Payments Between Interest and Principal

The allocation of payments between interest and principal for tax purposes may not be the same as the allocation shown on the Form 1098-E or other statement you receive from the lender or loan servicer. To make the allocation for tax purposes, a payment generally applies first to stated interest that remains unpaid as of the date the payment is due, second to any loan origination fees allocable to the payment, third to any capitalized interest that remains unpaid as of the date the payment is due, and fourth to the outstanding principal.

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Example.

In August 2003, Peg took out a $10,000 student loan to pay the tuition for her senior year of college. The lender charged a 3% loan origination fee ($300) that was withheld from the funds Peg received. The interest (5% simple) on this loan accrued while she completed her senior year and for 6 months after she graduated. At the end of that period, the lender determined the amount to be repaid by capitalizing all accrued but unpaid interest ($625 interest accrued from August 2003 through October 2004) and adding it to the outstanding principal balance of the loan. The loan is payable over 60 months, with a payment of $200.51 due on the first of each month, beginning November 2004.

Peg did not receive a Form 1098-E for 2004 from her lender because the amount of interest she paid did not require the lender to issue an information return. However, she did receive an account statement from the lender that showed the following 2004 payments on her outstanding loan of $10,625 ($10,000 principal + $625 accrued but unpaid interest).

Payment Date		Payment		Stated Interest		Principal
November 2004		$200.51		$44.27		$156.24
December 2004		$200.51		$43.62		$156.89
Totals		$401.02		$87.89		$313.13

To determine the amount of interest that could be deducted on the loan for 2004, Peg starts with the total amount of stated interest she paid, $87.89. Next, she uses a reasonable method to allocate the loan origination fee over the term of the loan ($300 ÷ 60 months = $5 per month). A total of $10 ($5 of each of the two principal payments) should be treated as interest for tax purposes. Peg then applies the unpaid capitalized interest to the two principal payments in the order in which they were made, and determines that the remaining amount of principal of both payments is treated as interest for tax purposes. Assuming that Peg qualifies to take the student loan interest deduction, she can deduct $401.02 ($87.89 + $10 + $303.13).

For 2005, Peg will continue to allocate $5 of the loan origination fee to the principal portion of each monthly payment she makes and treat that amount as interest for tax purposes. She also will apply the remaining amount of capitalized interest ($625 − $303.13 = $321.87) to the principal payments in the order in which they are made until the balance is zero, and treat those amounts as interest for tax purposes.

Taxmap/pubs/p970-019.htm#TXMP60681f88 Do Not Include As Interest

Interest

You cannot claim a student loan interest deduction for:

• Interest you paid on a loan if, under the terms of the loan, you are not legally obligated to make interest payments.
• Loan origination fees that are payments for property or services provided by the lender, such as commitment fees or processing costs.
• Interest you paid on a loan to the extent payments were made through your participation in the National Health Service Corps Loan Repayment Program (the "NHSC Loan Repayment Program") or certain other state loan repayment programs. This is effective beginning January 1, 2004. For more information, see Student Loan Repayment Assistance in chapter 5.

Taxmap/pubs/p970-019.htm#TXMP56e44b5c When Must Interest Be Paid

When Must Interest Be Paid

Beginning in 2002, you can deduct all interest you paid during the year on your student loan, including voluntary payments, until the loan is paid off. Prior to that, you could deduct only the interest paid during the first 60 months you were required to make interest payments on the loan.

If you started making required payments before 2002, and your payments continued into 2002 or later, see Table 4-2 and the example that follows. These illustrate how your student loan interest deduction may have changed.

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Example.

You took out a qualified student loan in 1994. Beginning October 1, 1996, you made a payment on the loan every month, as required. In September 2002, you received a small inheritance that allowed you to make an extra payment on your loan during October, November, December, and January. You made your final loan payment in August 2003. No student loan interest deduction was allowed before 1998. The following interest payments would qualify for deduction.

	1996:		None
	1997:		None
	1998:		12 payments (1st year deduction allowed)
	1999:		12 payments
	2000:		12 payments
	2001:		9 payments (60-month period ended in  September)
	2002:		15 payments (law changed - 12 required  + 3 voluntary payments)
	2003:		9 payments (8 required + 1 voluntary)

Previous Page:  Publication 970 - Tax Benefits for Education - Illustrated Example Next Page:  Publication 970 - Tax Benefits for Education - Can You Claim the Deduction Use     to find additional instances of index items.