Deducting Interest Paid On Student Loans (Even If You Don't Pay The Loans)

Kelly Phillips Erb for Forbes writes:  With the cost of a college education continuing to climb, more and more students are taking on student debt. Collectively, as a country, we currentlyowe $1 trillion in student loans.

I’ve been very open about the fact that I am still paying off my school loans. I could not have afforded to go to school without taking on some debt and I borrowed for college and for law school. I paid off my undergrad loans (whew!) but am still paying for law school.

To help ease the pain of paying off all of that debt, Congress has made it tax favorable. That hasn’t always been the case: beginning in 1986, you couldn’t claim a deduction for interest paid for personal reasons (one glaring exception being the home mortgage interest deduction). However, in 1997, as part of the Taxpayer Relief Act of 1997, interest paid for student loans was deemed to be deductible. For more on the history of student loans, check out this prior post.

Today, there is a deduction allowed for paying interest on a student loan used for higher education. The student loan interest deduction is available even if you don’t itemize. It’s technically as an adjustment to income but is sometimes called an “above the line” deduction since you reduce your taxable income on the front page of your return without regard to any deductions claimed on a Schedule A.

Of course, there are rules. This is tax law. There are always rules.

First, there is a cap on the amount of interest you can claim each year. You can reduce your income subject to tax by up to $2,500 of qualified student loan interest annually. This amount includes both required and voluntary interest payments – it’s not just what the loan folks want you to pay. The more you pay, the more you can deduct, assuming you don’t go over the cap.

Next , your student loan must have been taken out solely to pay qualified education expenses. This includes tuition and fees; books, supplies, and equipment; and other necessary expenses such as transportation. Room and board may also be included if the cost is not more than the allowance for room and board included in the cost of attendance at your school for federal financial aid purposes or the actual amount charged if you live in housing owned or operated by your school.

Now read this part carefully: the loan does not have to come solely from PHEAA, TERI or another institutional student loan provider. You can include other debt, such as credit cards and line of credit IF you use it only to pay student debt (don’t commingle). Bank and other loans also qualify but the borrowed funds cannot be from a related person or made under a qualified employer plan.

For purposes of the deduction, the student who borrowed the funds must be you, your spouse, or your dependent, and must have been enrolled at least half-time in a degree program when the loan was taken. And don’t get your terms confused! For purposes of the deduction, an individual can be your dependent even if you are the dependent of another taxpayer; even if the individual files a joint return with a spouse and even if the individual had gross income for the year that was equal to or more than the exemption amount for the year.

As with other education tax breaks, you must reduce your qualified education expenses by the total amount paid for employer-provided educational assistance; tax-free distribution of earnings from a Coverdell education savings account or a qualified tuition program (QTP); U.S. savings bond interest previously excluded from income; tax free scholarships, fellowships and grants; and veteran’s benefits.

You can typically deduct all of the interest you paid on your student loan until the loan is paid off. There are limits and phaseouts, however, depending on your income. The student loan interest deduction is phased out (reduced) if your modified adjusted gross income (MAGI) is between $60,000 and $75,000 ($125,000 and $155,000 if you file a joint return). You cannot take the student loan interest deduction at all if your MAGI is $75,000 or more ($155,000 or more if you file a joint return). Additionally, you may not deduct your student loan interest if you file as married filing separately or if someone else claims an exemption for you on his or her tax return.

And one more thing (this is the best part!): if someone else makes a payment on your behalf, you are treated as though you made the payment. Yes, you read that correctly. If, for example, your mom and dad pay some of your loans, you can still claim the interest for purposes of the deduction (but be careful and read the criteria above: if your parent claims you as a dependent but you are legally obligated to pay the loan, then neither one of you can take the deduction). There’s practically never the case in the Tax Code. Fantastic, right? It’s always nice to have someone help you out.