Death & Taxes

Interest Tax Deduction for School Loans

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By Roy Lewis
February 1, 2002

In 1997, a deduction was introduced for interest on qualified education loans. It applies to loan interest payments due and paid after 1997, regardless of when the loan was originally taken out. This deduction is an exception to the general rule that interest on "personal" loans isn't deductible.

Requirements for deductibility
The maximum amount of interest you can deduct is $2,500 in 2001 or later. The maximum isn't adjusted for inflation. However, the deductible amount is reduced for certain high-income taxpayers.

The interest must be for a "qualified education loan," i.e., for a debt incurred to pay tuition, room and board, and related expenses to attend a post-high school educational institution, including certain vocational schools. Certain post-graduate programs also qualify. Thus, an internship or residency program leading to a degree or certificate awarded by an institution of higher education, hospital, or healthcare facility offering post-graduate training can qualify.

For 2001 and prior years, only interest paid during the first 60 months that payments are required can qualify. Months in which payments aren't required, e.g., during a deferral or forbearance period, aren't counted against the 60-month period. In the case of an already existing loan, interest payments qualify for the deduction to the extent that the 60-month period has not yet expired. But months during which interest was paid before Jan. 1, 1998, would count against the 60-month period. For this purpose, a loan and all refinancings of the loan are treated as a single loan. (Loan consolidators and refinacers, exclaim with us now: "Rats!") Beginning in 2002, you can say adios to the 60-month rules.

Loan timing is important
Say you took out a loan to pay for your daughter's qualified education. She was your dependent at the time that you took out the loan, but has since graduated, is working, and is no longer your dependent. You can still deduct the interest that you pay on the loan (assuming that you otherwise qualify to do so) because she was your dependent when you took out the loan. Many people incorrectly think that as soon as the child is no longer a dependent, the interest is no longer deductible.

Income limitations
For 2001, if the taxpayer's status is married filing jointly, the deduction is only fully allowed for adjusted gross income of $60,000 or less. For taxpayers with AGI of $75,000 or more, no deduction is allowed. If AGI is between $60,000 and $75,000, the deduction is partially reduced, depending on how far above $60,000 the taxpayer's AGI happens to be. These income ranges will be indexed for inflation beginning after 2002. (These income limitations will change in 2002, but we'll get to that later.)

Example: If AGI is $65,000, the deduction is reduced by 33.3%, since the $5,000 excess above $60,000 represents 33.3% of the $15,000 excess that would result in complete disallowance.

For other taxpayers, such as single taxpayers, a full deduction is allowed if AGI is $40,000 or less. No deduction is allowed if AGI is $55,000 or more, and a similar partial disallowance approach is taken when AGI is between $40,000 and $55,000. (For these purposes, AGI is computed with certain modifications. For example, the exclusion of income from U.S. savings bonds used to pay higher-education costs isn't taken into account.)

Married taxpayers must file jointly or no deduction is allowed. Also, no deduction is allowed for a taxpayer who can be claimed as a dependent on the tax return of someone else. Where a deduction is allowed, it is taken "above-the-line" -- subtracted from gross income to determine adjusted gross income (AGI). Because of this above-the-line treatment, the interest deduction can be used by everyone who qualifies for it, regardless of whether you itemize your deductions or not.

The interest must be on funds borrowed to cover qualified education costs of the taxpayer or his spouse or dependent. The expenses must be for education furnished while the recipient was an "eligible student," i.e., at least a half-time student. Also, the education expenses must be paid or incurred within a reasonable time before or after the loan is taken out.

A closer look at the 60-month rule
While you can only deduct higher-education interest during the first 60 months in which interest payments are required, those 60 months don't have to be consecutive. In addition, months in which the loan is in deferral don't count against the 60-month period. For example, after paying interest on a college loan for 25 months, Hubert decides to go back to school. Under the terms of the loan, payments are deferred during the time he is in school. When he resumes making loan payments after his schooling ends, he will still have 35 months of deductible interest remaining.

But remember that if you refinance a loan, the months that have elapsed on the original loan are carried over to the new loan. For example, let's say that you have been paying off your qualified loan for the last 20 months, and you decide to refinance to take advantage of a lower interest rate. While the refinanced loan is "new," it is treated as a continuation of the original loan. This being the case, you will have only 40 months of remaining deductible interest.

Finally, remember that if you already have a higher-education loan outstanding, you may still be able to deduct up to 60 months of interest, depending on when the loan payment began. In some cases, interest payments on loans taken out many years ago will still be deductible in 2001.

Example: You began paying off a higher-education loan in July 1996, 42 months before January 2000. You will still be able to deduct a full 12 months of interest in 2000, and another six months in 2001 before your 60-month period expires. Better still: Even though you only received six months' worth of interest deductions in 2001, if you pay interest in 2002, you'll be able to claim that interest again because the 60-month rules are repealed for interest paid in 2002 or later years.

New rules for 2002 and beyond
For loan interest paid in 2002, the new tax act has removed the 60-month requirement from the student loan interest deduction provisions. Effective with interest paid in 2002, you're no longer prevented from deducting student loan interest because of the 60-month rule. As long as the interest qualifies for the deduction, it will be deductible regardless of how long the loans have been outstanding.

The income phase-out allowing for the student loan interest deduction has been increased for all filers. Beginning in 2002, the deduction will be phased out ratably for individual taxpayers with modified adjusted gross income of $50,000 to $65,000, and for taxpayers filing joint returns with modified AGI of $100,000 to $130,000. These phase-out ranges will be adjusted for inflation after 2002.

While these student loan interest deduction provisions can be a little tricky, it may be worth your while to look further into your ability to qualify for this deduction. If you have any additional questions or comments on these loan provisions, please post them online in the Tax Strategies discussion board.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.


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