Interest due and paid on a qualified education loan for qualified higher education expenses can be deducted (within limits) from adjusted gross income (AGI) (Sec. 221(a)). The deduction is an above-the-line deduction, so it is available regardless of whether a taxpayer itemizes deductions. Married taxpayers must file a joint return to claim the deduction, and no deduction is allowed to an individual if that individual is claimed as a dependent on another taxpayer’s return for the tax year (Secs. 221(e)(2) and (c)).The maximum amount of interest a taxpayer is permitted to deduct is $2,500, regardless of how many students are in the taxpayer’s family (Sec. 221(b)(1)).
The maximum allowable deduction phases out ratably when a taxpayer’s modified AGI exceeds certain amounts. Modified AGI is AGI without the deductions for education loan interest, qualified tuition and expenses, and domestic production activities and without the exclusions for (1) foreign earned income and housing costs and (2) income from certain U.S.possessions and Puerto Rico (Sec. 221(b)(2)(C)). For 2008, the deduction phases out ratably as modified AGI moves from $115,000 to $145,000 for married joint filers and $55,000 to $70,000 for single and head-of-household filers. The phaseout ranges are subject to annual inflation adjustments.
Example 1: H and W file a joint return in 2008. Their modified AGI is $125,000. Before considering the modified AGI limitation in 2008, they are entitled to a $1,000 student loan interest deduction. However, they are $10,000 ($125,000 – $115,000) into the $30,000 phaseout range for joint filers, so their student loan interest deduction for the year is limited to $667 [($30,000 – $10,000) ÷ $30,000 × $1,000].
Planning tip: The rule preventing claimed dependents from taking the deduction prevents parents who cannot claim the deduction because their income is too high from shifting the deduction to the student/child by having the child take out the education loan. However, a person (student) may claim a deduction for interest paid in later years when that person no longer qualifies as a dependent. Therefore, it may make sense for the student/child to take out the loan when payments will not be due until after graduation, at which point the child will presumably no longer be a dependent.
Only the taxpayer legally obligated to make interest payments under the terms of the education loan can claim the student loan interest deduction (Regs. Sec. 1.221-1(b)(1)). Therefore, parents cannot claim interest deductions on payments they make on loans for which their child is actually the borrower. In some instances, practitioners may need to inquire as to the actual borrowing arrangements or review the education loan documents to ensure a student loan interest deduction is properly claimed.
Cosigning a Qualified Education Loan
Parents occasionally are required to cosign their child’s education loans because of the student child’s lack of credit history. Where a parent cosigned the child’s education loan, both the IRS and the Tax Court have ruled that this made the parent and child jointly liable for the debt and thus allowed the parent to deduct interest paid on the child’s education loan (Rev. Rul. 71-179; Grubbs, TC Memo 1990-307). However, acting as a guarantor will not allow a parent to deduct interest payments made on the loan (Secunda, TC Memo 1977-185).
Planning tip: A parent’s cosigning an education loan provides flexibility for determining who will make payments on the loan and thus who will deduct the interest when the child is no longer a dependent. When the child is no longer a dependent, payments made by the child are deductible by the child, and payments made by the parent are deductible by the parent. The parent’s AGI phaseout levels and the marginal tax rates of both the parent and child should be considered in order to maximize the tax benefit.
Qualified Education Loan
A qualified education loan is any indebtedness incurred solely to pay for the qualified higher education expenses of the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer as of the time the indebtedness was incurred in attending (1) an eligible education institution (generally a college, university, postsecondary educational institution, or certain vocational schools eligible to participate in the student aid programs of the Department of Education, including virtually all accredited public, nonprofit, or proprietary postsecondary institutions); or (2) an institution conducting internship or residency programs leading to a degree or certificate from an institution of higher education, a hospital, or a health care facility conducting postgraduate training (Sec. 221(d)(1); Regs. Sec. 1.221-1(e)(1)). A list of eligible institutions can be searched in the school codes section of the U.S. Department of Education’s Free Application for Federal Student Aid website.
As long as the loan meets all other eligibility requirements, the deduction for interest does not depend on whether the loan is federally guaranteed or subsidized.
The higher education costs must be paid or incurred within a reasonable period of time before or after the indebtedness is incurred (Sec. 221(d)(1)(B)). For this purpose, the regulations provide a safe-harbor rule stating that the reasonable period requirement is met if the education loan proceeds are disbursed within a period beginning 90 days before the beginning and ending 90 days after the end of the academic period to which the higher education costs relate (Regs. Sec. 1.221-1(e)(3)(ii)). It is also deemed met if the expenses are paid with the proceeds of an educational loan that is part of a federal postsecondary education loan program. Actual tracing of the loan proceeds to the payment of the qualified higher education expenses is not required.
The expenses must have been incurred while the recipient of the loan proceeds was an “eligible student,” which means that he or she must have been enrolled at least half-time in a degree, certificate, or other program leading to a recognized educational credential at the institution, during the time that the qualified higher education expenses were incurred.
If the taxpayer has a qualified education loan and refinances the loan by taking out a new loan, the new loan qualifies as a qualified education loan (Sec. 221(d)(1)). A loan does not qualify as a qualified education loan, however, if the lender is related to the taxpayer within the meaning of Secs. 267(b) or 707(b)(1), or if the loan is from a qualified employer retirement plan (Sec. 221(d)(1)). Included in these related parties are related entities (e.g., trusts, more-than-50%-owned corporations, and partnerships) and members of the taxpayer’s family. Members of a taxpayer’s family include spouses, siblings (including half-brothers and half-sisters), parents and grandparents (or anyother ancestor), and children, grandchildren, or any other lineal descendants.
Caution: To qualify as an education loan, the debt must be incurred solely to pay qualifying higher education expenses. Mixed-use loans do not qualify (Regs. Sec. 1.221-1(e)(4), Example 6). Thus, a revolving line of credit generally will not constitute a qualified education loan unless the borrower certifies that the loan proceeds are used solely for paying higher education expenses (Notice 98-54). A borrower makes the certification by completing Form W-9S, Request for Student’s or Borrower’s Social Security Number and Certification, and delivering it to the lender.
Qualified Higher Education Expenses
Qualified higher education expenses for purposes of the deduction for student loan interest are generally the student’s cost of attending the educational institution, including tuition, fees, room and board, books, equipment, and related expenses (Regs. Sec. 1.221-1(e)(2)(i)). However, the expenses must be reduced by:
1. The exclusion from gross income for employer-provided educational assistance under Sec. 127;
2. The exclusion of income from U.S.savings bonds used to pay higher education expenses under Sec. 135;
3. The exclusion from income for distributions from an education savings account under Sec. 530 and qualified tuition programs under Sec. 529; and
4. The amount of any scholarship, veteran’s educational assistance, or any other nontaxable payment received for educational expenses (Regs.Sec. 1.221-1(e)(2)(ii)).
Loan Origination Fees and Capitalized Interest
Capitalized interest and certain fees are deductible as qualified education loan interest. Capitalized interest means any accrued and unpaid interest on a qualified education loan that, in accordance with the terms of the loan, is added by the lender to the outstanding balance of the loan (Regs. Sec. 1.221-1(f)(1)).
Example 2: Interest on T’s student loan accrues while she is in school, but she is not required to make any payments on the loan until six months after she graduates or otherwise leaves school. At that time, the lender rolls the accrued but unpaid interest into the outstanding principal amount of the loan. From that point forward, T must make monthly payments of interest and principal. The interest payable on the loan, including the capitalized interest, is original issue discount (OID) (Regs. Sec. 1.221-1(f)(4), Example 1).
Although OID normally is deductible as it accrues (Sec. 163(e) and Regs. Sec. 1.163-7), OID on a qualified education loan is not deductible until paid. A payment on an education loan is treated first as a payment of interest to the extent of any accrued interest as of the date of the payment, and second as payment of principal. This characterization of the payment as interest or principal applies regardless of how the parties label the payment (as interest or principal). Thus, taxpayers may be able to deduct a portion of a payment labeled as principal by the lender if the payment is allocable to capitalized interest (Regs. Sec. 1.221-1(f )(3)).
If a loan origination fee is paid to the lender in connection with an education loan and the fee is not for property or services provided by the lender, the fee reduces the issue price of the loan. This in turn creates or increases the OID on the loan in an amount equal to the fee (Regs. Sec. 1.1273-2(g)). Thus, the fee (such as points paid to secure the loan) is treated as capitalized interest (Regs. Sec. 1.221-1(f )(2)(ii)).
Payments of stated interest on a loan are treated as interest payments. Beyond this, any additional payments on the loan (regardless of the payment’s designation by the parties) are treated first as payment of deductible OID, to the extent of the OID that has accrued as of the date the payment is due (under Regs. Sec. 1.1272-1) and that has not been allocated to prior payments, and second as a principal payment (Regs. Sec. 1.221-1(f)(4), Example 2).
Example 3: Using the same facts as Example 2, assume the lender charges T a 1% loan origination fee, which is not for any property or services provided by the lender. The loan’s OID (which includes the capitalized interest and the loan origination fee) that accrues each year is determined under Sec. 1272 and Regs. Sec. 1.1272-1. In effect, the loan origination fee accrues over the life of the loan.
This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 8th Edition, by Anthony J. DeChellis, Patrick L. Young, James D. VanGrevenhof, and Delia D. Groat, published by Thomson Tax & Accounting, Ft. Worth, TX, 2007 ((800) 323-8724; ppc.thomson.com ).