Tax Implications of Student Loan Debt
It’s that time of year again, when Americans dash to accountants’ offices and free-file sites to get their tax returns submitted before the April 15th IRS deadline. It can be chaotic and nerve-racking, as folks try track up as many deductions and credits as possible to pay Uncle Sam as little possible, maybe even walking away with a refund. And for people paying back student loans, there is an additional set of rules and guidelines that govern the process.
One would be hard-pressed to qualify student loan repayment as “fun,” but being a responsible borrower can certainly net some benefit come tax time. Read on to learn how.
Gather your materials.
If you have student loan debt, each of your lenders should issue an IRS From 1098-E that will detail the amount of interest paid on the loan during the year (Click here if you are unsure of your loan provider). It is still important, however, to document your own payment history.
“In some cases, if you paid less than $600 in interest, you may not have received a 1098-E,” says certified financial planner Trace Tisler, “but that doesn’t mean you’re not eligible to claim the tax benefit. Contact your loan provider and ask them to provide you a statement showing the interest you paid. It’s always best to get something in writing if you can. Alternatively, you can consult your own records.”
Regarding the form used to file, the student loan interest deduction is only available on IRS Forms 1040 (line 33) and 1040A, so individuals filing without the help of a tax professional should avoid the 1040EZ.
Be aware of deduction limits.
On tax returns, interest paid on student loans is technically “an adjustment to income and available regardless of whether you claim the standard deduction or itemize,” says Tisler. But with that said, it’s important to remember that only $2,500 worth of interest can be deducted.
“Student loans and taxes are like feeding a gorilla wheat thins,” explains Jonathan Bochese, the senior managing licensed tax professional at the Tax Defense Network. “Most students have more debt than their yearly income and therefore pay large amounts of interest on minimum payments. [The $2,500 deduction allowed] is fine for single or even married people who have a lower amount of student loan debt. However, if you look at a married couple, each with professional degrees, and compare the amount of interest paid to the amount allowed, the difference is staggering. We’re talking tens of thousands of dollars here.”
Verify your eligibility.
Once you’re ready to file and have calculated how much of your student loan debt you can deduct, it’s time to determine whether you’re actually eligible to make that deduction. There are income restrictions put in place by the IRS that limit deductions if your modified adjusted gross income is over $60,000 for a single filer or $125,000 for those married filing jointly. The deduction is completely eliminated if income exceeds $75,000 for singles or $155,000 for couples (those limits will be slightly higher in 2014).
You can check the IRS Form 1040 instructions to see if this applies to you. And, adds Bochese, “Remember that if you are married and filing separately from your spouse, you are not entitled to claim any student loan interest on either return.”
Additionally, if you are still claimed as a dependent by another tax filer, you cannot claim the deduction (though a parent can, if they are responsible for the educational costs of the dependent). “If the student is the borrower, the deduction will be available for interest paid by the student in years when the student is not claimed as a dependent,” explains Tom Kinasz, a partner with Holland & Knight law firm.
When all is forgiven…
Generally, a student loan deferment or default will not affect tax filing, outside of minimizing any potential deduction, if less (or no) interest was paid over the year. But when a loan is actually cancelled, that could change. According to the IRS Publication 970, detailing educational tax benefits, “If you are responsible for making loan payments and the loan is cancelled (forgiven), you must include the amount that was forgiven in your gross income for tax purposes.” There are, however, certain circumstances in which that can be avoided.
“Some student loans are offered under programs that provide that the obligation to repay will be cancelled if the student performs certain services in a specified geographical area,” says Kinasz. “This might involve practicing medicine in rural communities or working in a qualified state hospital. If the student fulfills this public service requirement, some or all of the loan will be cancelled without any income tax due. It is important that the loan is made through a program that specifies the availability of these special incentives and that the borrower fulfills the service obligation to obtain the tax-free cancellation advantage.”