FEDTAX * IRS * HOME * PUB_970

Publication 970
Tax Benefits for Education

For use in preparing 2002 Returns

3. Student Loans

Important Changes for 2002

60-month limit eliminated.   Beginning in 2002, you are no longer limited to deducting interest paid only during the first 60 months that interest payments are required.

Voluntary interest payments deductible.   All student loan interest payments (both required and voluntary) you make on or after January 1, 2002, may be deductible. For further information, see Voluntary interest payments, under Include As Interest, later.

Income limits on phaseout of deduction increased.   The amount of your student loan interest deduction for 2002 will be phased out (gradually reduced) if your modified adjusted gross income (MAGI) is between $50,000 and $65,000 ($100,000 and $130,000 if you file a joint return). You will not be able to take a deduction if your MAGI is $65,000 or more ($130,000 or more if you file a joint return). This is an increase from the 2001 limits of $40,000 and $55,000 ($60,000 and $75,000 if filing a joint return). See Does the Amount of Your Income Affect the Amount of Your Deduction, later.

New modification to adjusted gross income (AGI).   Beginning in 2002, for purposes of the phaseout of the deduction, you must add back to your AGI any qualified tuition and fees deducted on Form 1040 or 1040A. Your modified adjusted gross income (MAGI) is your AGI before subtracting any deduction for student loan interest, but with certain other deductions and exclusions added back in. For more information, see Modified adjusted gross income (MAGI), under Does the Amount of Your Income Affect the Amount of Your Deduction.

Qualified higher education expenses may be reduced.   Beginning in 2002, you must reduce your qualified higher education expenses by the amount of earnings distributed from a qualified tuition program (QTP) and excluded from income. See What Are Qualified Higher Education Expenses, later.

Important Change for 2003

Phaseout ranges adjusted for inflation.   Beginning in 2003, the income ranges for phasing out the student loan interest deduction may be adjusted annually for inflation.

Introduction

This chapter describes the following two tax benefits related to student loans.

  1. The student loan interest deduction.
  2. Canceled (forgiven) student loans.

Student Loan Interest Deduction

If you paid interest on a student loan in 2002, you may be able to deduct up to $2,500 of the interest you paid.

If you pay $600 or more in interest during the year to a single lender, you should receive a statement at the end of the year from the lender showing the amount of interest you paid. That information will help you complete your tax return.

What is the tax benefit of the student loan interest deduction?   The student loan interest deduction can reduce the amount of your income subject to tax by up to $2,500 in 2002.

This 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).

Table 3-1 summarizes the features of the student loan interest deduction.

Do not rely on this table alone. Refer to the text for complete details.

Table 3-1.  Student Loan Interest Deduction At a Glance
Feature Description
Maximum benefit You can decrease your income up to $2,500.
Loan qualifications Your student loan
· must have been taken out solely to pay qualified education expenses, and
· cannot be from a related person or made under a qualified employer plan.
Student qualifications The student must be
· you, your spouse, or your dependent, and
· enrolled at least half-time in a degree program.
Time limit on deduction Beginning with payments made in 2002, you can deduct interest paid during the remaining period of your student loan.
Phaseout The amount of your deduction depends on your income level.

What Is Student Loan Interest?

Generally, student loan interest is interest you paid during the year on a loan you took out to pay qualified higher education expenses (defined later) that were:

  1. For you, your spouse, or a person who was your dependent (defined later under Can You Claim the Deduction?) when you took out the loan,
  2. Paid within a reasonable period of time (defined later under Can You Claim the Deduction?) before or after you took out the loan, and
  3. For an eligible student (defined later under Can You Claim the Deduction?).

Include As Interest

Loan origination fees (other than fees for services), capitalized interest, interest on revolving lines of credit, and interest on refinanced student loans are student loan interest if all other requirements are met. Beginning in 2002, you can deduct all remaining interest paid during the life of the loan, including both required and voluntary interest payments.

Loan origination fees.   These are the costs of getting the loan.

Capitalized interest.   This is unpaid interest on a student loan that is added by the lender to the outstanding principal balance of the loan.

Interest on revolving lines of credit.   Revolving lines of credit, such as credit card debt, qualify if the borrower uses the line of credit (credit card) only to pay qualified higher education expenses. See What Are Qualified Higher Education Expenses, later in this chapter.

Interest on refinanced student loans.   These loans include 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.

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.

Example.   The payments on Roger's student loan were scheduled to begin in June 2001, 6 months after he graduated from college. He began making payments as required. In September 2002, 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, 2002. Even though these were voluntary (not required) payments, Roger can deduct the interest paid in October and November.

All remaining interest paid during life of the loan.   Beginning in 2002, you can deduct all interest you pay on your student loan, including voluntary payments, until the loan is paid off. Prior to that date, 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 continue into 2002 or later, see Table 3-2 and the example that follows. These illustrate how your student loan interest deduction may change.

Table 3-2. Changes in Allowable Deduction Period for Student Loan Interest
Year You Made Interest Payments Interest Deduction Allowed
Before 1998 No deduction allowed.
1998 - 2001 Interest paid during the first 60 months that interest payments are required on the student loan.
2002 and later All interest paid on student loan during year, both required and voluntary payments.

Example.   You took out a 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, and December. 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 (end of 60-month period)
  2002:   15 payments (law changed - 12 required + 3 voluntary payments)

Do Not Include As Interest

You cannot claim a student loan interest deduction for interest on any of the following loans.

  • A loan from a related person.
  • A loan from a qualified employer plan.
  • A loan for which you were not legally liable.

Loan from a 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.

Loan from a 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.

Loan for which you are not legally liable.   You cannot deduct interest on a loan if, under the terms of the loan, you are not legally obligated to make interest payments.

Example.   Susan took out a qualified education loan in 1999 to finance 2 years of college for herself. She was the sole person responsible for the loan. In 2001, after she finished attending school, Susan made the first three payments on the loan. In 2002, Susan's mother helped her with the payments, paying a total of $750 of interest during the year. Neither Susan nor her mother can deduct the $750 interest on their 2002 tax returns. Susan cannot deduct it because she did not pay it. Her mother cannot deduct the interest because she is not legally obligated to pay it. This is true whether or not Susan's mother claims her as a dependent.

Can You Claim the Deduction?

Generally, you can claim the deduction if all of the following requirements are met.

  1. Your filing status is any filing status except married filing separately.
  2. No one else is claiming an exemption for you on his or her tax return.
  3. You paid interest on a loan you took out only to pay tuition and other qualified higher education expenses for yourself, your spouse, or someone who was your dependent when the loan was taken out.
  4. The education expenses were paid or incurred within a reasonable period of time before or after the loan was taken out.
  5. The person for whom the expenses were paid or incurred was an eligible student.

Many of the terms used in the above list are explained later in this chapter.

Is Someone Else Claiming Your Exemption?

Another taxpayer is claiming an exemption for you if he or she lists your name and other required information on line 6c of his or her Form 1040 (or Form 1040A).

What Are Qualified Higher Education Expenses?

Generally, these expenses are the total costs of attending an eligible educational institution, including graduate school. They include the costs of:

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

The expense for 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.

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

  • Employer-provided educational assistance benefits. See chapter 9.
  • Tax-free withdrawals from a Coverdell ESA (formerly known as an education IRA). See chapter 5.
  • Tax-free withdrawals from a qualified tuition program. See chapter 6.
  • U.S. savings bond interest that you exclude from income because it is used to pay qualified higher education expenses. See chapter 8.
  • Certain scholarships. See Publication 520.
  • Veterans' educational assistance benefits.
  • Any other nontaxable payments (other than gifts, bequests, or inheritances) received for education expenses.

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.

For purposes of the student loan interest deduction, the term 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.

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

No Double Benefit Allowed

You cannot deduct as interest on a student loan any amount you can deduct under any other provision of the tax law (for example, home mortgage interest).

Who Is a Dependent?

Generally, a 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.

More information about dependents can be found in Publication 501, Exemptions, Standard Deduction, and Filing Information.

What Is a Reasonable Period of Time?

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

Even if they are 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 particular academic period, and
  2. The loan proceeds are disbursed within a period that begins 60 days before the start of that academic period and ends 60 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.

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.

Who Is an Eligible Student?

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

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 those established by the Department of Education under the Higher Education Act of 1965.

How Much Can You Deduct?

Your student loan interest deduction for 2002 is generally the smaller of:

  1. $2,500, or
  2. Your interest payments that were paid in 2002.

However, the amount determined above may be gradually reduced (phased out) or eliminated based on your filing status and modified adjusted gross income (MAGI) as explained next under Does the Amount of Your Income Affect the Amount of Your Deduction.

Does the Amount of Your Income Affect the Amount of Your Deduction?

The amount of your student loan interest deduction is phased out (gradually reduced) if your MAGI is between $50,000 and $65,000 ($100,000 and $130,000 if you file a joint return). You cannot take a student loan interest deduction if your MAGI is $65,000 or more ($130,000 or more if you file a joint return).

Table 3-3 describes the effect the amount of your MAGI has on the student loan interest deduction you are allowed to claim.

Table 3-3. Effect of MAGI on Student Loan Interest Deduction
IF your filing status is... AND your MAGI* is... THEN your student loan interest deduction is...
single, not more than $50,000 not affected by the phaseout.
head of household, more than $50,000 reduced because of the phaseout.
or qualifying widow(er) but less than $65,000
$65,000 or more eliminated by the phaseout.
married filing joint return not more than $100,000 not affected by the phaseout.
more than $100,000 reduced because of the phaseout.
but less than $130,000
$130,000 or more eliminated by the phaseout.
* Beginning in 2003, amounts will be adjusted for inflation.   

How the phaseout works.   To figure the phaseout, multiply your interest deduction (before the phaseout) by a fraction. The numerator is your MAGI minus $50,000 ($100,000 in the case of a joint return). The denominator is $15,000 ($30,000 in the case of a joint return). Subtract the result from your deduction (before the phaseout). This result is the amount you can deduct.

Example 1.   During 2002 you paid $800 interest on a qualified student loan. Your 2002 MAGI is $125,000 and you are filing a joint return. You must reduce your deduction by $667, figured as follows.

  $800 × $125,000 - $100,000 = $667  
  $30,000  

Example 2.   The facts are the same as in Example 1 except that you paid $2,750 interest. Your maximum deduction for 2002 is $2,500. You must reduce your maximum deduction by $2,083, figured as follows.

  $2,500 × $125,000 - $100,000 = $2,083  
  $30,000  


Modified adjusted gross income (MAGI).   For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return before subtracting any deduction for student loan interest.

MAGI when using Form 1040A.   If you file Form 1040A, your MAGI is the AGI on line 22 of that form figured without taking into account any amount on line 18 (Student loan interest deduction) or line 19 (Tuition and fees deduction).

MAGI when using Form 1040.   If you file Form 1040, your MAGI is the AGI on line 36 of that form figured without taking into account any amount on line 25 (Student loan interest deduction) or line 26 (Tuition and fees deduction), and modified by adding back any:

  1. Foreign earned income exclusion,
  2. Foreign housing exclusion,
  3. Foreign housing deduction,
  4. Exclusion of income for bona fide residents of American Samoa, and
  5. Exclusion of income from Puerto Rico.

- Continue -