A taxpayer is allowed a deduction in computing adjusted gross income (an above-the-line deduction) for interest (student loan interest) paid on qualified education loans. The maximum annual deduction is $2,500, but the amount otherwise deductible is phased out ratably for taxpayers with modified AGI of $50,000 to $65,000 ($100,000 to $130,000 for joint returns).
Example 1: Your client’s daughter, a single taxpayer, paid $3,000 in student loan interest in 2003 when her modified adjusted gross income was $40,000. She could deduct $2,500 of the interest she paid.
Example 2: The facts are the same as in Example 1, except that the daughter’s modified AGI in 2003 was $56,000. She could only deduct $1,500 of her student loan interest — i.e., 40 percent of the otherwise allowable deduction was phased out since she was 40 percent ($6,000 of $15,000) into the phase-out range.
The phase-out applies to the lesser of the amount of student loan interest paid in the year, or the maximum amount of student loan interest deductible if there was no phase-out.
Example 3: The facts are the same as in Example 2, except that your client’s daughter paid only $2,000 in student loan interest in 2003. She can deduct only $1,200 of the amount paid, i.e., 60 percent of the amount she paid since 40 percent of that amount was phased out.
Qualified education loans
A qualified education loan is any indebtedness incurred by the taxpayer solely to pay qualified higher education expenses that:
- Are incurred on behalf of a student who is the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer as of the time the indebtedness was incurred;
- Are paid or incurred within a reasonable period of time before or after the indebtedness is incurred; and,
- Are attributable to education furnished during an academic period when the recipient was an eligible student.
Example 4: Your client, who files a joint return with his wife, took out a loan in 1999 to pay for the college education of his daughter, who was his dependent at that time. In 2003, when his daughter was working and self-supporting, and no longer qualified as your client’s dependent, your client paid $2,000 in interest on the loan.As long as his modified AGI for 2003 didn’t exceed $100,000, your client could deduct the entire amount of interest that he paid on the loan, since his daughter was his dependent when the loan was made.
A loan (mixed-use loan) is not a qualified education loan if part of the proceeds of the loan can be used for another purpose.
Example 5: Your client has signed a promissory note for a loan secured by her residence. Part of the loan proceeds were used to pay for improvements to the residence, and part were used to pay qualified higher education expenses of her son.
Since the loan wasn’t incurred solely to pay qualified higher education expenses, the loan isn’t a qualified education loan.
Observation: If other requirements are met, your client may be able to deduct the entire interest she pays on the loan in Example 5 as mortgage interest on a residence. However, the entire amount would have to be deducted as an itemized deduction. No part could be used to reduce AGI.
Similarly, revolving credit lines aren’t qualified education loans, unless the borrower uses the line of credit solely to pay qualifying education expenses. Such revolving lines of credit include, for example, credit card debt and a university’s in-house deferred payment plan, which is a revolving credit account that can include a variety of expenditures in addition to qualified higher education expenses.
Also, a qualified education loan doesn’t include any indebtedness owed to a person who is related to the taxpayer within the meaning of Internal Revenue Code § 267(b) (barring deduction of losses from sales or exchanges between related persons) or IRC § 707(b)(1) (disallowing losses on sales of property with respect to controlled partnerships). For example, a loan from a parent, grandparent, brother or sister of the borrower isn’t a qualified education loan.
Nor does a qualified education loan include any indebtedness owed to any person by reason of a loan under any qualified employer plan (as defined in Internal Revenue Code § 72(p)(4)) or under any contract referred to in IRC § 72(p)(5) (i.e., a contract that was bought under a qualified employer plan).
A loan doesn’t have to be issued or guaranteed under a federal post-secondary education loan program to be a qualified education loan. A loan from a commercial bank can qualify.
Allocating payments to principal or interest
Payments are generally treated first as a payment of interest to the extent of the interest that has accrued and is unpaid, and second as a payment of principal. This rule applies regardless of how the parties label the payment.
Example 6: Interest on your client’s loan accrued while she was in school, but she wasn’t required to make any payments on the loan until six months after her graduation. At that time, the lender capitalizes the accrued interest and adds it to the principal amount of the loan, and the borrower must make monthly payments of interest and principal.
The interest payable on the loan, including the capitalized interest, is original interest discount. Your client may deduct payments that, under the OID rules, are treated as payments of interest, including any principal payments that are treated as payments of capitalized interest.
Interest paid by someone other than the taxpayer
The student loan interest deduction is available only for interest paid by the taxpayer on a qualified education loan. However, if the interest is paid by a third party who is not legally obligated to make the payment, the taxpayer is treated as receiving the payment from the third party and, in turn, making the payment. However, the deduction is not available to an individual who for that year is claimed as a dependent by another person.
Example 7: Your client’s daughter obtained a qualified education loan to attend college. After graduation, she worked as an intern for a nonprofit organization. As part of the program, the organization makes an interest payment for her after the deferment period.
The payment is treated as additional compensation to your client’s daughter, but, assuming that all other requirements are met, she can deduct the payment of interest.
Observation: If, in Example 7, the interest payment from the employer was more than $2,500, the full amount would be included by your client’s daughter as compensation income, but her student loan interest deduction would be limited to $2,500 (or the phase-out limit if modified AGI exceeds the threshold).
Example 8: Your client’s son obtained a qualified education loan to attend college. Your client, who cannot claim her son as a dependent, makes a required monthly interest payment as a gift to him. Assuming all other requirements are met, your client’s son can deduct that payment of interest.
Effect of refinancing a qualified education loan
A qualified education loan includes indebtedness used solely to refinance indebtedness that qualifies as a qualified education loan. A single, consolidated indebtedness incurred solely to refinance two or more qualified education loans of a borrower is itself treated as a qualified education loan.
If a taxpayer refinances a qualified higher education loan and receives an amount in excess of the original qualified education loan, the taxpayer may deduct the interest paid on the refinanced loan only if the taxpayer uses the excess amount solely to pay higher education expenses and satisfies all other requirements of a qualified education loan. If the taxpayer uses the excess for any other purpose, the refinanced loan isn’t used solely to pay higher education expenses, and no interest on the loan will be deductible.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
