March 03, 2017
Most people are aware that there are a number of ways to claim tax benefits from the payment of college education expenses. In fact, this area of the law is so important and complex that there is an entire IRS Publication (Pub. 970) that is devoted solely to tax benefits for education. Additionally, there can be state or local income tax consequences for the education expenses. This article is not intended to cover these extensive rules.
However, if you or your dependent had college expenses that were largely offset by a scholarship, and you weren’t able to claim the maximum available tax credit or deduction – read on! Almost all tax software and tax return preparers will take your Form 1098-T for tuition, add any required book expenses, subtract any scholarships received, and use the net figure to calculate your tax refund. If your college expenses were largely offset by scholarships, this may mean that your tax benefit is small or zero using this method.
Under a little known IRS regulation (Treas. Reg. §1.25A-5(c)(3)), a scholarship that by its terms may be applied to expenses other than qualifying tuition and related expenses (for example, room and board), may be optionally treated as taxable income on the student’s tax return. In some cases, this may even cover scholarships that are measured by reference to tuition, but that may be used for non-qualifying expenses.
At first glimpse, this seems like a terrible option – who wants more taxable income? However, many students pay little or no tax on their income, and this treatment allows the taxable scholarship to avoid subtraction in the calculation of the education tax credit. Additionally, most college students are treated as tax dependents by their parents, so the student will record this income (probably with little or no tax due), and the parent could potentially claim a much larger tax benefit for the college expenses.
I realize this is very confusing, so to illustrate it, consider the following example:
A student pays $4,000 of tuition and $5,000 of room and board to South Dakota State University, and received a $4,000 scholarship that could be applied to either expense. The expenses qualify for the American Opportunity Tax Credit. The default tax treatment is to subtract the $4,000 scholarship from the tuition, resulting in zero expenses qualifying for a credit. However, the student could opt to treat the scholarship as used against the room and board, and therefore fully taxable to the student. The student is a dependent, and their parent can now claim the $4,000 of tuition, resulting in a $2,500 American Opportunity Tax Credit. If the student didn’t pay any tax on the income, the net effect is a positive $2,500 for the parent. Even if the student paid 15% tax on the income, there is still an overall benefit of $1,900 ($2,500 education credit, minus $600 of taxes paid by student).
If you have scholarships that are reducing your education tax credits – don’t give up! This little known strategy could allow you to salvage a substantial tax credit.
There are many nuances to this strategy, so please consult your tax advisor. This article is intended to serve as general guidance, and should not be construed as specific tax advice for your situation.
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