Federal Tax Rules Change for Student Loan Deductions
Tax deductions for paying interest on student loans just got more lucrative, but also more complex, thanks to new rules put out by the Treasury Department this month.
The rules, which clarify and implement federal tax policy, will allow borrowers to write off hundreds -- even thousands -- of dollars in fees and so-called capitalized interest costs that previously could not be deducted.
There’s one big hitch -- borrowers may have to do some sleuthing to figure out just how much of a write-off they can take.
“The fear is that the Treasury may have turned an already complicated process into a nightmare,” said Shelly Repp, general counsel at the National Council of Higher Education Loan Programs in Washington.
How do the rules work and how might they affect you? Here are a few answers.
Question: What do the new rules do?
Answer: The most significant change is that both loan origination fees (which can amount to 3% of the total loan amount) and so-called capitalized interest expenses can be deducted as qualified student loan interest expenses.
Capitalized interest is the amount of interest that accumulates on unsubsidized college loans while the student is in school and the loans are in deferment. These costs are generally added to the principal of the loan. Depending on market interest rates and how long the loan remains unpaid -- deferments can span four years of college, graduate school and stretches of unemployment -- the capitalized interest costs can be substantial.
In the past, both capitalized interest and loan origination fees have been mixed in with the principal payments reported on loan statements to borrowers and have not been broken out as separate, deductible interest expenses.
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Q: Then how do I know how much to deduct if my old loan statements don’t show these costs as interest payments?
A: It’s not easy. Starting this September, the new rules will require lenders to calculate the proper amounts and report them to borrowers on annual tax forms. But those who want to claim the deductions for 2003 and before have to figure the appropriate amount themselves.
On the bright side, lenders usually have records showing how much each borrower has paid in origination fees and capitalized interest. They’ll provide these figures to borrowers who ask, Repp said. The borrower should then divide that amount by the term of the loan to get the amount of the heretofore unreported annual interest deductions.
In other words, if the capitalized interest and fees amount to about $2,500 on a $10,000 loan -- which isn’t unusual -- the borrower would divide $2,500 by the number of years of the loan. That would be added to the interest expenses that the lender has already reported to get a total loan interest deduction, which is claimed on Line 25 of the 1040.
On a 10-year loan, that would boost this borrower’s deductible interest expense by $250 annually -- an amount worth $75 in tax savings to someone paying 30% of their income in federal and state income taxes.
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Q: Can I go back and claim these deductions for past years?
A: Yes. If you paid student loan interest in past tax years, you may file an amended return on a Form 1040X. Returns can be amended for only three years after filing, which gives April filers the ability to go back to 2001 returns, which would have been filed by April 15, 2002.
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Q: Do you have to itemize to claim these deductions?
A: No. They are a so-called before-the-line deduction, which means that they can be claimed on the front page of the 1040, without filling out an itemized deduction form.
In addition, like IRA contributions, this deduction reduces adjusted gross income. And AGI is the figure used for most other income-tested deductions, so claiming these write-offs could boost the taxpayer’s ability to claim other deductions and credits -- such as the child tax credit -- as well.
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Q: Can a parent or grandparent claim student loan interest deductions if they make the payments on a child’s loan?
A: No. According to the new rules, loan repayments that are made by someone who is not legally obligated to repay the loan will be treated as a gift to the borrower. The deduction is not lost, however. It is just passed on to the borrower-student, who can claim credit for the interest that his relative paid for him.
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Q: That doesn’t seem fair. Is there any way to become “legally obligated” to pay the loan after the fact, so that I can claim the expenses that I’m paying anyway?
A: These rules open the door to refinancing a student debt -- even with a private loan -- and deducting the interest as a qualified education loan. However, the loan cannot be used for anything but paying off another student debt to qualify.
Parents and grandparents who consider this should be cautious, however. Federally guaranteed student debt is highly flexible, allowing payments to be put on hiatus if the borrower loses a job or goes back to school. Other types of loans are not as accommodating. Don’t refinance a student loan to get a tax deduction if there’s even a slight chance that you will be unable to repay the loan in full.
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Q: Do these rules apply to loans taken out by parents to pay their children’s college costs?
A: Yes. In this case, the parent is the borrower and gets the tax deduction for the interest expenses.
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Q: Can anyone with student debt take student loan interest deductions?
A: No. The deductions phase out for those earning more than set amounts. In 2004, student loan interest is fully deductible for singles earning up to $50,000 and married couples with up to $100,000 in income.
Once income exceeds the thresholds, the deductions phase out until they’re eliminated for single taxpayers earning more than $65,000 and couples earning more than $130,000.
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Kathy M. Kristof, author of “Investing 101” and “Taming the Tuition Tiger,” welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com.
