When debtors are struggling with the payments, even tiny benefits and facilitation seems significant. One of such benefits can be interest deduction, which is a way to adjust the income. The amount of student loan interest deduction can be as high as $2500. However, it has an extensive eligibility requirement. From the school attended to loan type, every element has its qualification standards for the interest deduction from expenses covered to interest paid. Besides, depending on the income, the deduction amount can change.
As loan interest deduction is a complex topic to understand, this guide will break it down into details. We tried to be as clear as possible. However, people who lack financial understanding can still have a difficult time understanding the terms. Hence, if you face such a problem, it is advisable to contact Student Loans Resolved. Our experts will analyze the situation you face and guide you throughout the whole process.
General Information about Student Loan Interest Deduction
Usually, the interest payments are not tax-deductible. However, there exist exceptions to this rule. First, some loan types and interests, such as certain mortgage payments, can be tax-deductible. Additionally, if the debtor’s Modified Adjusted Gross Income (MAGI) is less than $85000, he/she can get a loan interest deduction. For a joint return, this amount is increased to $170000. However, the amount of reduction will decrease as people approach the MAGI limit.
MAGI is shown in the tax return for many borrowers, and it covers the income before deducting any interest. Currently, the student loan interest deduction cap is either $2500 or limited to the interest paid in the year. When deciding on the deduction, the lower amount between these two options will be chosen.
Though the student loan interest deduction seems attractive, one should understand its eligibility requirements. There are many qualifying conditions for the loan, student, expenses, school, interest, etc.
Eligibility Requirements for Loan
Student loan interest is the rate borrowers pay during a year for student debt. Interest includes both the mandatory payments and the voluntary ones borrowers make in addition to the required interest rate. Borrowers should keep in mind that the interest is applied to qualifying loans. In the context of student loan interest deduction, the qualifying loan is the one taken to cover educational costs. This loan can be for the borrower, his/her spouse, or a dependent. The loan is only eligible if it covers costs of education during the time the borrower studies. Besides, it should be paid within a reasonable time period.
If a borrower takes loans from a related person or an employer, such sources are not eligible for the deduction process. In more detail, student loan interest deduction cannot be applied to a related person. A related person can be a spouse, sibling, half-sibling, parent, grandparent, children, or grandchildren, as well as partnerships or trusts.
Who is Dependent?
In general, the borrower’s dependent can be his/her children or a relative. Some conditions also make any other person a dependent if the borrower claims it on the return. However, when the dependent has $4,200 or more gross income and filed a joint return, the case would not be applied.
How to Define Reasonable Time?
As mentioned before, the borrower will have a qualified loan if the debt covers the education costs in a reasonable time. However, this phrase needs further explanation. Reasonable time can be different depending on the student loan type. For example, if the borrower benefits from a federal loan for post-secondary education, the requirement is the same as mentioned. In the case of different loan types, a reasonable time is specified with two conditions. First, the education cost should be for a specific academic time. Second, the money you get from the loan is paid out in the period covering 90 days before the academic period till 90 days after the period ends. There can be cases where these conditions do not apply. In such a situation, the reasonable time is determined by considering the specifics of the circumstance.
For further explanation, borrowers should know that the school defines the academic period. It can be a semester, trimester, quarter, summer school, or if the school uses credit hours, then the academic period is any payment time.
Who is an Eligible Student?
Eligible students should study at least half-time in a school providing a degree, certificate, etc. Half-time is determined by considering half of the full-time work for the study. However, it is best determined by the school policies. The half-time cannot be lower than the standard set by the Higher Education Act, 1965.
What is Included in Education Cost?
We mentioned education cost a lot while explaining the qualification requirements. However, borrowers in need of student loan interest deduction can be confused about what is included in this cost. Eligible educational expenses are all the costs incurred to attend a school. Any academic cost element, including tuition, accommodation, supplies, books, or equipment, can be included. Besides, if there exist unavoidable, significant costs like transportation, it will also be added.
Borrowers need to be careful about accommodation costs. In general, the IRS will cover such expenses to an extent shown in the school’s policies about the cost of attendance. The school provides information about funds needed for room and board in the documents to use federal aid purposes. There, they show the amount of money needed for such accommodation for a particular period. Hence, usually, the accommodation cost cannot be greater than this amount. The exception applies when a borrower stays in the housing provided by the school.
Some tax-free items cannot be a part of the education cost applicable to student loan interest deduction. If a borrower benefits from such items, the benefit should be deducted from the total education cost. These benefits can include employer or veteran assistance, tax-free earnings from Coverdell education savings account, Qualified Tuition Program, scholarships, etc.
Educational Institution/School Attended
The eligibility requirements for a qualifying school is so broad that almost all accredited and post-secondary institutions qualify for student loan interest deduction. In more detail, borrowers should attend a school that has accreditation. Public institutions, as well as non-profit, privately-owned colleges, vocational schools, are eligible. Besides, the school should be eligible for the federal aid program that the Department of Education provides.
The qualification requirements for student loan interest deduction even covers some schools outside the U.S. Plus, an institution conducting internship, residency program and provides a degree can be eligible.
The even greater benefit of this term is that all the eligibility requirements only apply to the period the borrower studied. If the educational institution loses the eligibility status after the student’s attendance period, it will not negatively affect the student loan interest deduction process.
If you cannot identify if the school is eligible in the context of student loan interest deduction, you can get this information by asking the school officials. The institution should be able to share this information.
What is Included in Interest?
People interested in student loan interest deduction might not realize that ‘interest’ is more than the monthly rate paid to repay the federal debt. Besides the original interest rate, other items are also included in this content. One of them is the origination fee, which lenders take once when they lend the money. These fees should be required for the money’s use purpose instead of for services such as commitment or processing fees. In this case, the fee will be a part of the debt, which accrues interest. Therefore, it can be deductible as interest.
Usually, the origination fee is shown in Form 1098-E. However, debtors, who borrowed funds before 2004 might lack this information in the form. Such borrowers can utilize a reasonable alternative method to allocate the fees on loan.
Besides the origination fee, capitalized interest is also considered deductible interest. When the borrower does not pay the interest, the lender can add it to the outstanding balance. For loan interest deduction purposes, such a capitalized amount is treated as interest. This case will only happen if a debtor made a payment during a year. Otherwise, no payment for a year will eliminate the deduction benefit for capitalized amounts.
Sometimes, even the interest of credit card debt can benefit from student loan interest deduction. However, there is a requirement for this case which covers the purpose of the debt. If the debtor uses the credit card debt to pay eligible education costs, he/she can get a deduction. Plus, borrowers who utilize Refinancing or Debt Consolidation programs can receive interest deductions. Yet, if the borrower received more debt while refinancing and used some portion for other purposes than education, the loan will not qualify for the deduction.
What is not Included in Interest?
For student loan interest deduction purposes, we have already discussed which amounts are considered as interest. In this section, we will go through what is not treated as interest to simplify the information:
- If the borrower is not legally obliged to make interest payments, the amount he/she paid will not qualify for the deduction.
- Origination fees could be a part of interest, but the fees paid for the property or the service itself will not qualify.
- There exist conditions for the Health Service Corps Loan Repayment and other programs.
Also, keep in mind that any eligible interest made during the year voluntarily can benefit from the deduction. However, this benefit is applicable until the student debt is repaid fully.
Who can Claim the Interest Deduction?
Besides all the details mentioned above, there are general conditions for people who can claim the interest deduction. Not surprisingly, the borrower should be legally obliged to pay the interest and actually makes the payment. Debtors should consider that they cannot be dependents in anyone’s tax return. Such cases happen when someone puts the borrower’s name on Form 1040, Form 1040-SR, or 1040-NR as a dependent. For example, if the parent of the borrower shows the debtor as dependent on the tax return. In this case, none of them will benefit from the interest deduction. Lastly, except for student loan interest deduction married filing separately, other filing statuses qualify.
It is also possible to get a deduction when another party makes the payment on behalf of the borrower. For instance, an organization where the borrower works voluntarily can make the payment as extra compensation, or a friend can pay the interest as a gift. In such conditions, the interest will qualify for the deduction.
Recently, there were some updates on student loan interest deduction policies. First, there is no double benefit granted. It means, if the debtor already has a deductible interest based on other tax laws, he/she cannot deduct the interest again. Besides, as mentioned before, the Qualified Tuition Program provided student loans cannot benefit from interest deduction.
Additionally, the student loan interest deduction income limit for different borrower types changed. Based on the 2019 number, if the borrower earned Modified Adjusted Gross Income of $70000-$85000, his/her original deduction amount will decrease. This limitation is doubled for a joint return, so between MAGI of $140000-$160000, the interest deduction will be reduced. We will explain how to calculate the reduced interest deduction in detail in the following parts.
How Much is the Deduction?
Student loan interest deduction cap is either $2500 or the interest paid during the year. When deciding on the amount, the smaller one is chosen between these two options. However, the amount can be lower depending on the filing status and Modified Adjusted Gross Income. We will discuss such conditions in the subsequent section.
Modified Adjusted Gross Income (MAGI) is the income before deducting any loan interest. This amount is usually shown in the tax return. Usually, the conditions mentioned above apply to the student loan interest deduction income limit till $70000. If the MAGI is between $70000-$85000, the borrower’s interest deduction amount will gradually decrease, called the student loan interest deduction phase-out. In the joint return, the student loan interest deduction income limit is till $140000. For such borrowers, the deduction amount decreases in the range of $140000-$170000 income. If the borrower’s MAGI is $85000 or more, there will be no accessible student loan interest deduction. For married filing/joint return, borrowers with a minimum of $170000 will not qualify for the deduction benefit.
The Modified Adjusted Gross Income also depends on what type of form is used. There are different conditions for Form 1040-NR, 1040-NR-EZ, 1040, etc. For more information, borrowers can get Student Loans Resolved expert advice or read the IRS publication 970.
How to Calculate Reduced Deduction?
As mentioned before, the student loan interest deduction will be reduced if the debtor’s income is between specified limits. In this case, they can estimate how much the deduction will decrease. Borrowers can get this number in several steps:
- Determine the deduction amount without student loan interest deduction phase-out(reduction)
- Multiply with the fraction with the numerator showing the difference between the MAGI and the lower phase-out limit. This limit is $70000 for single, and $140000 for married filing. The denominator will be $15000 for single people and $30000 for a joint return.
- Subtract the resulting number from the original deduction amount found in the first stage.
Example. If the original deduction amount is $600, Magi is $80000, and it is for a single person, the new deduction will be $600*($80000-$70000)/$15000= $400. Therefore, the deduction is reduced by $200 ($600-$400). You can also use a student loan interest deduction calculator.
Difficult to Follow? Contact Us
While we try to explain everything in detail, we understand that the terms and eligibility requirements can still be difficult for the borrowers. If you feel lost among too much information, it is time to contact Student Loans Resolved. We work with a team of experts in the debt management sector. Our specialists have extensive information about any kind of tax benefit provided by the Internal Revenue Service, including student loan interest deduction. By collecting information about the current conditions you face, they will be able to make suggestions and guide you throughout the process. Whenever you have a question or face a challenge, our team will be by your side. Do not waste time and contact us now to know more about the tax return benefits.
Other Tax Benefit
Student loan interest deduction is not the only way of receiving tax benefits. Several other programs, such as Coverdell Education Savings, Qualified Tuition Program, and withdrawal options also exist.
Tax Benefit for Education Expenses
When students make expenses for education, they can get help from tax credits to cover some costs. The education expenses such as the tuition fee, book, equipment, etc., for college or career school, qualify for such benefit.
American Opportunity Credit
One of such programs is American Opportunity Credit. It helps students to get $2500 per academic year for four years. However, students should be cautious. An individual who claims this benefit and does not qualify for the program can be banned. As a result, he/she will not be able to claim this credit for up to 10 years.
Keep in mind that American Opportunity credit does not give the students money to cover the costs. The program helps to offset the educational costs by providing tax reductions. Hence, its amount highly depends on the income level. Besides, if you claim this credit, you cannot claim another tax reduction, such as Lifetime Learning Credit.
However, American Opportunity Credit can bring a 40% refund. It means, if after the deduction, the tax amount is negative, a student can get refunded.
There also exists a limit on the Modified Average Gross Income of people who can be eligible for this program. For single filing, this limit is $90000, while for married filing, the cap is $18000. Besides, students should be studying at least half time for an academic period during 2019.
Lifetime Learning Credit
Another program for covering the education costs is Lifetime Learning Credit. It reduces the tax maximum of $2000 per year. While student loan interest deduction reduces the tax amount, a credit decreases the tax amount directly. There is also a federal limit for Modified Average Gross Income: $68000 for single and $1360000 for married return. Unfortunately, this program is non-refundable. However, different from American Opportunity Credit, this credit has no limits for the number of years.
If the income is between $58000 and $68000, the phase-out will apply, similar to the student loan interest deduction phase-out. This process also happens for joint filing, but the income range is between $116000 and $136000. Individuals with more Modified Adjusted Gross Income than $68000 or $136000, in case of a joint return, will not be eligible for Lifetime Learning Credit.
Difference between American Opportunity and Lifetime Learning Credit
Although both programs help to cover education costs, there exist some differences. One of the most important factors that distinguish these two programs is the limit on years. If a student wants to benefit from American Opportunity Credit, he/she can apply only for four years. However, there is no limit on the Lifetime Learning Credit. Additionally, American Opportunity Credit provides a 40% refund, while the Lifetime Learning Credit is non-refundable.
Besides, students should consider that American Opportunity Credit is a better option if they qualify for both programs. The reason for such recommendation is that American Opportunity Credit provides higher benefits.
Students who do not normally file a tax return should start doing so because refundable programs can even bring money into their pockets.
Coverdell Education Savings Account
This program is different from the previously mentioned student loan interest deduction or tax credits. Coverdell Education Savings Account is simply an account opened in the bank for a beneficiary. Beneficiaries should be less than 18 or have special needs. Anyone can put money into this account to pay the education expenses of the beneficiary. Such distributions will be tax-free.
Qualified Tuition Reduction
Students who do not pay tuition fees or pay reduced amounts do not need to add this benefit to their income. As a result, they will not pay taxes from such education, called Qualified Tuition Reduction. However, qualifying students are the ones studying in eligible educational institutions. Sometimes, the students might receive tuition reduction from one institution and use this benefit in another school. In this case, both entities should be qualifying for this program. The eligibility requirements also change, depending on the study type. Undergraduate and graduate students face different conditions.
Eligibility for Undergraduate Students
First, students who benefit from an employee of a qualifying institution will be eligible for the program. Besides, if the student was once the employee but retired or left on disability, the eligibility still holds. Their widows will also be eligible if the student meets the mentioned condition dies. Lastly, dependent children or the spouses of the first-mentioned condition can enjoy this benefit.
If the parents of the child died, the child is dependent till 25. For divorced parents, the child is dependent on both of them.
Tuition fee can be tax-free if it meets two conditions:
- A qualifying institution provides tuition-free benefit
- A student performs teaching or research activities
Which Program to Choose?
As you are already familiar, the Internal Revenue Service provides many opportunities as tax return benefits. This guide mostly focused on the student loan interest deduction and gave some information about the tax credits, saving account, or Qualified Tuition Reduction. Each of these programs has extensive eligibility requirements, including tiny details that are easy not to notice. However, the consequences of applying while being ineligible can be harmful. For example, if the ineligible people claim the benefit in American Opportunity Credit, they can be banned from credit claims between 2-10 years. Besides, getting one type of benefit can eliminate your chance of utilizing other programs.
Hence, it is of utmost importance to choose the right program and apply for the tax return benefits properly. You can get more information on the Internal Revenue Service’s official website about such programs, including student loan interest deduction. Yet, the terms used and the way the information presented can be challenging to understand. The policies mention technical terms frequently, which makes it difficult for readers. Therefore, it is advisable to contact a third-party expert, like those in Student Loans Resolved, to clarify the points you do not understand. Additionally, our experts can guide you through the whole process, from the very beginning till the end.
Interest Deduction Summarized
In general, student loan interest deduction offers a maximum $2500 benefit. If the total payments per year are less than $2500, then the payment amounts will be considered a benefit. Eligibility criteria require loans to be taken for educational purposes, and the lender of the loan cannot be a relative or employer. In turn, the beneficiary can be a student, his/her spouse, or dependent. Besides, the student should study at least half-time in a qualifying school. Lastly, a student loan interest deduction income limit is either $85000 or $170000, for single and joint returns, respectively. However, one needs to read the details mentioned in this guide thoroughly to picture this benefit fully.