Student Loans and Tax Breaks

In general, interest paid on personal loans is not deductible for federal income tax purposes, except for certain mortgage interest. In recognition of the burgeoning costs of higher education, a special deduction was instituted in 1998 allowing for a deduction on interest paid on student loans.

The Student Loan Interest Deduction
This deduction can reduce taxable income by a maximum of $2,500 per tax year under certain circumstances. Basically it is for interest paid by the taxpayer on a "qualified student loan" during the tax year. As a result of a 2001 amendment to the Internal Revenue Code, the deduction may now be taken for the entire remaining period of each loan.

This deduction has an added advantage in that it may be taken as an adjustment to income, and therefore does not require that the taxpayer itemize deductions in order to claim the benefit. Lending institutions that receive more than $600 in interest payments on qualified student loan interest during the tax year are required to give each borrower a Form 1098-E by February 2 of the following year to assist in calculating the deduction.

Primary Requirements for Claiming the Student Loan Deduction

• The deduction is available for interest paid during the tax year on a loan taken out solely to pay "qualified education expenses" for the taxpayer, the taxpayer's spouse, or a dependent (as determined at the time the loan was taken out). A dependent is generally defined as an individual who received most of his or her support from the taxpayer, was related to or lived with the taxpayer, and was a citizen of the U.S., Canada, or Mexico.
• The expenses must have been paid or incurred within a reasonable period of time before or after the loan was taken out. This has been interpreted to mean that the expenses must usually relate to a specific academic period and the loan proceeds were dispersed between 60 days before the start and 60 days after the end of that academic period.
• The expenses were paid for an "eligible student" during an academic period. "Eligible student" is defined as one enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential.
• "Qualified education expenses" are the total cost of attending an "eligible educational institution," including tuition and fees, room and board (under certain circumstances), books, supplies, equipment, and other necessary expenses (such as transportation).
• The IRS advises that eligible educational institutions include virtually all accredited public, non-profit, and privately-owned profit making schools, e.g., colleges, universities, vocational schools or other post-secondary institutions. The term also encompasses institutions conducting an internship or residency program leading to a degree or certificate from an institute of higher education, a hospital, or a health care facility that offers postgraduate training.
• Deductible interest is defined broadly to include loan origination fees, interest on refinanced student loans, interest on credit cards (if the advances were used for eligible expenses), "capitalized" interest (unpaid interest added to principal), and even interest voluntarily paid.

Some Restrictions on Claiming the Student Loan Deduction

• The loan cannot originate from a qualified employer plan or a "related person," e.g. spouse, parents, siblings, half-siblings, "ancestors" (grandparents, aunts and uncles, etc.), descendants (children, grandchildren, etc.), and certain organizations or entities.
• The loan may not include interest payments that the taxpayer is not legally obligated to make.
• The deduction cannot be claimed by taxpayers who are married and filing separately.
• This deduction cannot be claimed by anyone who is listed as a dependent in the "exemption" section of another's tax return.
• The taxpayer must have actually made the interest payments during the tax year.
• Sums deducted under any other provision of the tax laws, such as home mortgage interest, cannot also be deducted as student loan interest.
• The deduction is not available for taxpayers with modified adjusted gross income (MAGI) above specified amounts on individual or joint tax returns. The deduction is also subject to a "phase out," i.e., taxpayers with individual or joint MAGI within certain ranges may only claim a fraction of the deduction, or may not be entitled to any deduction at all depending on their MAGI. MAGI, as used here, represents gross income prior to deduction for student interest and itemized deductions, with certain other income added that may not usually be included in gross income for certain taxpayers, i.e., income earned abroad or in Puerto Rico or American Samoa.