Student Loan Interest Deduction

By Mark Kantrowitz

The student loan interest deduction has allowed borrowers to deduct up to $2,500 a year in interest paid on federal and private student loans on their federal income tax returns since the 1998 tax year.

The student loan interest deduction is taken as an above-the-line exclusion from income, so taxpayers do not have to itemize to claim the deduction. Instead, they can claim both the student loan interest deduction and the standard deduction.

Financial Impact

Since the student loan interest deduction is an above-the-line exclusion from income, it reduces the taxpayer's adjusted gross income (AGI). The reduction in AGI can yield other benefits, such as qualifying the taxpayer for other tax benefits and reducing susceptibility to the alternative minimum tax (AMT).

According to IRS statistics of income, the average student loan interest deduction is about $1,000, saving about $250 per taxpayer. Since the student loan interest deduction phases out in the 25% tax bracket, the maximum reduction in tax liability for a borrower claiming the full $2,500 deduction is $625.

Eligibility

Taxpayers can claim the student loan interest deduction only if they are legally obligated to pay the interest as a borrower or cosigner of the federal or private student loan. Voluntary payments by others count as though they were made by the borrower.

If the borrower could have been claimed as a dependent on someone else's federal income tax return, the borrower cannot claim the student loan interest deduction. For example, if the borrower could be claimed as a dependent on his or her parent's federal income tax return, the borrower is not eligible to claim the student loan interest deduction. Moreover, the parent cannot claim the student loan interest deduction unless the parent cosigned the student's loans.

The interest must have been paid during the tax year for the borrower to claim the student loan interest deduction. For example, interest that accrues during a forbearance but is unpaid cannot be claimed until it is paid by the borrower. On the other hand, interest that accrues and is paid during a partial forbearance, where the borrower makes interest-only payments, is eligible for the student loan interest deduction. If the borrower voluntarily pays the interest during the in-school and/or grace periods, the interest is eligible for the student loan interest deduction.

Origination fees and capitalized interest are amortized over the term of the loan for the purpose of the student loan interest deduction.

Only qualified education loans are eligible for the student loan interest deduction, as defined in the Internal Revenue Code of 1986 at 26 USC 221(d). In particular, mixed-use loans like credit cards are not eligible, nor is debt owed to someone who is related to the borrower. The loan must have been used to pay for qualified higher education expenses at a college or university that is eligible for Title IV federal student aid. Loans from qualified retirement plans are also not eligible. If a qualified education loan is refinanced, it is still eligible for the student loan interest deduction, so long as the new loan was used solely to refinance qualified education loans.

Note that there is a marriage penalty inherent in the student loan interest deduction. Married borrowers who file a joint income tax return are entitled to just one student loan interest deduction of up to $2,500, not two. (Married borrowers who file separate returns are not eligible for the student loan interest deduction.)

Income Phaseouts

The income phaseouts are adjusted annually according to inflation, rounded down to the next lowest multiple of $5,000. The 2017 income phaseouts are shown in this table.

Resources

Additional sources of information include:

• Student Loan Interest Deduction (Chapter 4 of IRS Publication 970)
• IRS Form 1098-E (Student Loan Interest Statement)
• Interactive tax assistant for evaluating eligibility for the student loan interest deduction
• Section 26 USC 221 of the Internal Revenue Code of 1986
• The regulations at 26 CFR 1.221-1 (2002 and later) or 26 CFR 1.221-2 (prior to 2002)