Tax tip: Student loan interest deduction

Out of all of the seasons that we look forward to throughout the year, tax season is generally not one of them. All of the forms, calculations, and software needed for filing can get exhausting. But the best part about it is the opportunity to maximize your return, and student loans can play an important role in doing so. Depending on the type of loan, a student loan interest deduction may be available. Ask your tax professional and possibly a financial aid advisor at your institution to discover how you can take advantage of the opportunity.

You may deduct up to $2,500, which is equivalent of up to $500 reduction in your tax liability depending on the federal tax bracket you belong to. A qualified loan must have been taken out for the singular purpose of paying education expenses and cannot be from a related person or made under an eligible employer plan. Many of us also use credit cards regularly to pay for supplies and fees.

Overview of qualifications

As with any other tax element a federal income tax return must be filed in order to determine your eligibility. To help calculate your student loan interest deduction, use the IRS Form 1040 (Line 33) or Form 1040A (Line 18). Below are the basic factors for student loan interest deduction qualification:

• You must be paying interest on a loan used only for higher education costs incurred during enrollment at least half-time in a program leading to a degree, certificate or recognized credential.
• Your modified adjusted gross income must be $75,000 or less if single and $155,000 or less if married and filing together. You may not claim this deduction if your filing status is “married filing separately.”
• Education expenses include tuition, fees, room and board, books, supplies, mandatory student activity fees and other necessary costs such as transportation.
• If you are claimed as a dependent on another’s tax return such as your parents, only the party who claims you can apply for the interest deduction.

Types of interest

Once eligibility is determined, analyzing what types of interest exist is the next step. The Internal Revenue Service (IRS) provides detailed examples of the categories of interest and how they are applied which include:

• Loan Origination Fees – These up-front fees are charged by a loan lender as payment for processing a new loan application. They are quoted as a percentage of the total 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 –This type, which includes interest on credit card debt, is student loan interest if the borrower uses plastic to pay for all education costs.
• Interest on Refinanced Student Loans – Consolidated and collapsed loans both apply to this category. Be very careful with this type. You will not be able to deduct any interest paid on a refinanced loan if you refinance a qualified loan for more than the original loan and use the extra funding for any purpose other than education expenses.
• Voluntary Interest Payments – These are payments made to a student loan during a time period when interest payments are not mandatory. For example when the borrower is allowed to defer payment or during a grace period before repayment status is official.

It is important to note that the deduction benefit applies to loans made on or after September 1, 2014 due to form structure and the fact that the information was not required for filing before this date. Those with loans submitted prior to this date may be able to deduct additional loan origination fees and capitalized interest. The IRS states that given this timeline and requirements change, the person filing can use any “reasonable method to allocate the origination fees over the life of the loan.” To help visualize what this means, consider the following case study:

“In August 2004, Bill took out a student loan for $16,000 to pay the tuition for his senior year of college. The lender charged a 3% loan origination fee ($480) that was withheld from the funds Bill received. Bill began making payments on his student loan in 2013. Because the loan origination fee was not included in his 2013 Form 1098-E, Bill can use any reasonable method to allocate that fee over the term of the loan. Bill's loan is payable in 120 equal monthly payments. He allocates the $480 fee equally over the total number of payments ($480 ÷ 120 months = $4 per month). Bill made 7 payments in 2013, so he paid $28 ($4 × 7) of interest attributable to the loan origination fee. To determine his student loan interest deduction, he will add the $28 to the amount of other interest reported to him on Form 1098-E.”

In the situation above, Bill uses a method that allocates equal portions of the loan origination fee to each payment required by the loan terms. Unfortunately the calculation method is flawed and results in a double deduction of the same portion of a loan origination fee, which would not be a reasonable way to determine the amount.

The bottom line

It is clear that attaining a higher education degree often requires a significant financial investment, but many students can easily underestimate how federal tax returns can contribute to long term economic wellbeing. Understanding the student loan interest deduction is part of that. This overview provides a snapshot of one benefit you may qualify for. Remember to consult your personal finance professionals for additional tips and do your research. After all homework can benefit your wallet as well as your grades!