This article explains the nature of the Lifetime Learning Credit (LTC), eligibility, qualifying expenses, the amount and limitations, and how to report them on form 1040 and supporting schedules. (Click here to read the first article.)

Eligibility

 

The credits may be claimed for yourself, a spouse, or dependents claimed as an exemption. Expenses paid by someone other than the student are considered to have been paid by the student. This means the student is eligible to claim the credit on their return even though someone else pays the expenses. For a parent or other taxpayer to claim the credit, the student must be claimed as a dependent on their return. If the student is not claimed as a dependent on another taxpayer’s return, only the student can claim the credit (even if someone else pays the expenses). If both the student and another taxpayer are eligible to claim the credit, it should be taken by the one obtains the most tax savings. If taxpayers paying the expenses are married at the end of the tax year, they must file a joint return. However, if they are married, but separated, and one spouse files as head of household, that person is eligible to claim the credit. Both the American Opportunity and Lifetime credits cannot be claimed in the same year for the same student. If a taxpayer is eligible for both credits, they should use the one that provides the most tax savings.

Unlike the American Opportunity credit, there is no limit on how many years the credit can be claimed. This credit is for post-undergraduate education part time or full time at qualified educational institutions. It includes graduate non degree or degree courses, and continuing education classes, to improve or acquire job skills. Courses also include sports or hobby-related activities that are part of the student’s degree program and improve or help the student acquire job skills.

Qualified Expenses

 

These include tuition and fees (reduced by scholarships and grants) reported on Form 1098T, books, supplies, and equipment required for classes. Equipment must be purchased from the educational institution. Room and board is not an eligible expense. Any expenses must also be reduced by tax free education benefits paid by an employer, veterans educational assistance, and other tax free amount excluded from gross income other than a gift, bequest, device, and inheritance.

Expenses can be paid from Section 529 and Coverdell ESA accounts and borrowed funds. If borrowed funds are sent directly to the school, they aren’t considered paid until the school credits the student’s account. Amounts prepaid for a semester beginning in the first three months of the next tax year must be taken in the year in which the courses are taken. This situation occurred when a student paid expenses paid in December 2011 for the semester starting in February 2012. The IRS disallowed the credit for 2011. The IRS was upheld by the Tax Court [Lucas Matthew McCarville, TC Summary Opinion 2016-14]. If a payment is made for an academic period beginning after March 15 of the next year, the payment is not eligible for either the year it is paid or for the next year when courses are taken [J.K. Lasser’s Your Income Tax, 2016 and Instructions for Form 8863].

If a deduction for education expenses is claimed on Schedule A as a miscellaneous itemized deduction or Schedule C, a credit cannot also be claimed.

Amount of the credit

 

The credit is 20% of the first $10,000 of qualified expenses and is limited to the tax due and is not refundable. Any unused credit cannot be carried forward. If a taxpayer claims the AOC, the LTC cannot be claimed in the sane year for the same student. If the taxpayer is eligible for both credits they should claim the one that provides the most tax savings. The credit is phased out at 20% of MAGI between $55,000 and $65,000 for married filing separate, single, surviving spouse and head of household ($110,000 and $130,000 for married filing joint). The credit is zero when MAGI exceeds $65,000 for married filing separate, single, surviving spouse and head of household ($130,000 for married filing a joint return).

Example 1

 

Claire’s dependent daughter Angelica is enrolled at Siena College in the M.S. in Taxation program. Her expenses are: tuition $20,000, an $800 laptop computer required for classes purchased from Siena, and books $500. She received a scholarship of $8,000 applied to tuition. Her qualified education expenses are $13,300 [(20,000 – 8,000) + 800 + 500]. Claire’s MAGI is $58,000 and her tax before credits and withholding is $1,500. Claire’s tentative credit is $2,000 (20% of the first $10,000 of expenses). The phase out for excess MAGI is $600 [(.20% x (58,000 – 55,000)]. Her LTC will be $1,400 (2,000 – 600). Since her tax is more than the LTC, she can claim a $1,400 LTC on her 2015 tax return filed March 1, 2016.

Example 2

 

Assume the same facts but Claire’s tax is $1,200. Her LTC is limited to $1,200 and the remainder is non-refundable.

Entering Information for the Education Credit on the Tax Return

 

Tax return preparation software contains supporting schedules to support Form 8863. These schedules are used to determine if the taxpayer is eligible for the credit, the name, address and social security of the of student, name and address of the educational institution, type and amount of education expenses, and type of credit being claimed (AOC or LTC). Software programs have an optimizer which determines if a deduction or a credit provides the greatest benefit and computes the allowable amount.

If the software program determines the taxpayer is eligible for the credit, it will complete Form 8863 which must be attached to the tax return (supporting schedules aren’t required to be sent with the return but is advisable to do so). Form 8863 shows the allowable LTC based on the expenses on the supporting schedule and MAGI. The allowable credit is transferred to Form 1040, line 68 (line 44, Form 1040A).

Credit Recapture

 

If you receive a refund of tax free educational assistance for the qualified expenses or qualified expenses in the NEXT year after filing your tax return for the year the credit is taken, any excess credit must be recaptured (paid back) by reporting the excess credit as additional tax on the tax return for year tin which the refund is received. The excess is determined by recomputing the credit based on expenses after any refund and subtract that from the original amount claimed.

Example

 

Assume the same facts as Example 1 above except Angelica withdrew from school on April 15, 2016 and received a tuition refund of $5,000. Her education expenses after the refund will be $8,300 (13,500 – 5,000). Her new credit before the MAGI phase out will be $1,660 (.2 x 8,300). The credit after the MAGI phase out will be $1,060 (1,660 – 600 MAGI phase out). The excess credit is $1,400 previous credit – 1,060 revised credit). This will be reported as additional tax on her 2016 tax return.

Tax Planning Tip for Recipients of Pell Grants, Scholarships or Fellowships

 

These amounts reduce the allowable education expenses but taxpayers may be able to avoid this situation with careful planning. The IRS Instructions for Form 8863 states that any scholarship or fellowship grant is not treated as tax-free to the extent the student includes the amount in income or may be applied to room and board which is not a qualified expense for the credit.

The education credit may be able to be increased if the student or other taxpayer paying the expenses elects to include the educational assistance in income. The scholarship or grant must qualify as tax-free and must be one that may be used for expenses other than tuition and fees; even the school may apply the grant or other educational assistance to tuition and fees. If this election is made, the student must include in income the amount applied to other expenses. This allows expenses not paid by educational assistance to be applied to qualified educational expenses, increasing the credit.

Like Pell grants and scholarships, amounts withdrawn from Section 529 and Coverdell ESA accounts, can be allocated to education expenses in any manner the parties desire. The credit can be claimed in the year the beneficiary takes the distributions, but both amounts cannot be used to pay the same expenses in the same year [See examples in Part 1, “The American Opportunity Credit”].

Refunds of expenses paid on behalf of a student

 

If a student receives a refund in the same year that the expenses were paid, the refund reduces the eligible expenses, assuming it was not for room and board. A refund of part of the room and board has no effect since these are not qualified expenses. The same rule applies if the refund is received in the next year but before the tax return is filed. If the refund is received in the next tax year after the tax return is filed, the refund may has to be paid back to the extent of the taxes reduced by the credit.