This article explains the nature of and eligibility rules, who can claim the credit, qualifying expenses, the amount and limitations, and how to report them on form 1040 and supporting schedules.

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 other taxpayer are eligible to claim the credit, it should be taken by the person that 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.

The credit is for the students’ first four years of undergraduate study. The student must be:

(1) enrolled at least half time (as defined by the school) for at least one academic period that begins during the calendar year in a program that leads to a degree, or certificate program or other recognized educational credential.

(2) must not have a felony conviction for possessing or distributing controlled substances.

(3) be enrolled in an eligible institution defined by the IRC. This is an accredited public, private, or proprietary college, university, vocational school or other post-secondary four or two year institution eligible to participate in the student aid program administered by U.S. Department of Education .The student does not have to be enrolled in consecutive terms. 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.

Qualified Expenses

 

These include tuition and fees (reduced by scholarships and grants) reported on Form 1098T, books, supplies and equipment required for classes. Equipment can be purchased either from private sources or 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 Sect. 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}.

Amount of the Credit

 

For 2015, the credit for each student is 100% of the first $2,000 of qualified expenses, plus 25% of the next $2,000. If the credit exceeds the tax due, 40% of the remainder is refundable. The credit is phased out at 15% of MAGI in excess of $80, 000 for married filing separate, single, surviving spouse and head of household ($160,000 for married filing joint). The credit is zero when MAGI exceeds $90,000 for married filing separate, single, surviving spouse and head of household ($180,000 for married filing joint).

Example (from J.K. Lasser’s Your Income Tax 2016)

 

Ron and Jackie are married and file a joint return and claim their two children as dependents. In 2016, their daughter Claire was a full time student at University of Albany and their son Gabe was a full time student at Union College in Schenectady, NY. Their MAGI is $163,000. They paid qualified education expenses of $7,000 for Claire and $8,500 for Gabe ($15,500 total). Their tentative education credit is $5,000 [4,000-first 2,000 for each child, plus 1,000 (.25 x the next 2,000 for each child)]. Their excess MAGI is $3,000 (163,000 – 160,000). Their credit is $4,250 (5,000 tentative credit reduced by $750 (.15 x 3,000)] which exceeded their tax liability by $1,250. 40% of the excess is a refundable (.4 x 1,250 = 1,700). The non-refundable amount is $2,550 (4,250 – 1,700).

Both the American Opportunity and Lifetime Learning credits (see Part II) cannot be claimed in the same year for the same person. If a taxpayer is eligible for both credits, they should use the one that provides the most tax savings.

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 AOC and LTC based on the expenses on the supporting schedule and MAGI. The allowable credit is transferred to Form 1040, line 68 (line 44 for Form 1040A). Any refundable credit is entered on form 1040, line 68 as an amount paid-in.

Credit Recapture: (IRS Instructions for Form 8863)

 

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 return filed for the year in 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

 

In December 2015, Claire paid $5,000 for her dependent daughter Theresa’s education expenses for the semester starting January 2016. Claire filed her return on February 15, 2016 and claimed a $2,500 AOC credit [2,000 +. (25 x 2,000)]. In April, Theresa withdrew from school and received a $2,000 refund for tuition paid in December 2015. The education expenses after the refund is $3,000. Claire’s recomputed credit is $2,250 [2,000 + (.25 x 1,000)]. The excess credit is $250 which must be reported as additional tax when she files 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 any scholarship or fellowship grant is not treated as tax-free to the extent the student includes the amount in income or applied to other amounts (e.g. room and board) which are not qualified expenses.

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 if the school applies it 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.

Examples

 

1. Jordan, Barb’s dependent daughter, finished high school in May 2015 and enrolled at University at Albany to major in accounting. Both Barb and Jordan qualify for the AOC. Jordan’s tuition and fees are $5,000 and room and board is $4,000. Jordan has $5,000 in qualified education expenses because room and board does not qualify. She received a $5,000 tax free Pell grant which may be used to pay ANY of the expenses. She took out a $2,750 student loan and Barb paid the remaining $1,250. Barb and Jordan choose to use the Pell grant to pay the tuition. Since it was applied to tuition, it is not included in income but must be used to reduce tuition. Jordan cannot have an education credit since her expenses are zero Barb cannot claim the credit because the amount she paid was for room and board.

2. The same facts apply except only $1,000 of the Pell grant is applied to the tuition and the remaining $4,000 of the Pell grant is applied to room and board which must be included in income leaving $1,000 as a tax free scholarship. After the scholarship, Jordan has $4,000 in qualified education expenses. Barb cannot claim the credit because the amount she paid was for room and board. Jordan‘s tax liability before the credit is $500. She can claim a credit of $1,000 [(2,000 + .25 x 2,000)]. Her refundable credit will be $200 [.4 x (1,000 – 500)].

A tax free distribution from a Section 529 or Coverdell ESA can be applied to either qualified education expenses or other items, such as room and board without increasing the tax liability for the student. An education credit can be taken in the same year the student takes the tax free distribution if both distributions are not used for the same expenses [IRS Instructions for Form 8863].