Sec. 221 final regs. on deducting qualified education loan interest.

In May 2004, Treasury issued final regulations (TD 9125) to clarify the rules on deducting interest on qualified education loam under Sec. 221.

Background

Sec. 221 was enacted by the Taxpayer Relief Act of 1997. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) amended its provisions, to (1) increase the income limit for the deduction and (2) eliminate the 60-month period for the deduction and the restriction disallowing a deduction for payments during a deferment. The EGTRRA amendments apply to interest paid on loans after 2001 and before 2011. As a result, in 2011, the pre-2002 rules will again apply, unless the EGTRRA amendments are extended or made permanent.

To accommodate the dual sets of rules, the regulations are divided into two parts, Regs. Sec. 1.221-1 addresses qualified education loan interest paid from 2002-2010, inclusive; Reg. Sec. 1.221-2 applies to such interest paid from 1998-2001 and after 2010. This item focuses on Regs. Sec. 1.221-1.

General Rules

Sec. 221 (a) provides that individuals may deduct interest paid during the tax year on qualified education loans. Sec. 221(d) defines this as a loan obtained to refinance other qualified education loans or to pay qualified higher education expenses (QHEEs) for an eligible student at an eligible educational institution. The "eligible student" can be the taxpayer or his or her spouse or dependent. Under Regs. Sec. 1.2211(e)(3)(i) and (e)(3)(v)(A), the boa rowed funds must be used solely to pay QHEEs or refinance qualified education loans; if any part is used for other purposes, it is not a qualified education loan.

Further, under Sec. 221(d), flush language, and Regs. Sec. 1.2211(e)(3)(iii), qualified education loans do not include loans a taxpayer obtains from related parties (as defined in Sec. 267(b) or 707(b)(1)). Thus, if the student borrows money from his or her grandparent, it is not a qualified education loan; any interest paid thereon would not be deductible. Other loans that do not qualify include those made under a qualified employer plan (under Sec. 72(p)(4)) or a contract identified in Sec. 72(p)(5). Kegs. Sec. 1.2211(e)(3)(iv) provides, however, that qualified education loans need not be issued or guaranteed under a Federal postsecondary education loan program.

QHEEs: Regs. Sec. 1.221-1(e)(2) defines QHEEs as the cost of attendance, including tuition and fees, room and board, books, supplies, transportation and miscellaneous student expenses. To ensure that a double benefit is not received, however, Regs. Sec. 1.221-1(e)(2)(ii) requires that the total cost be reduced by certain nontaxable amounts, including qualified scholarships (Sec. 117); educational assistance received by veterans or members of the armed forces (Chapter 30, 31, 32, or 35 of title 38, U.S. Code or Chapter 1606 of fide 10, U.S. Code); employer-provided and other excludible educational assistance (Secs. 127 and 25A(g)(2)(C)); savings bond interest excluded due to educational use (Sec. 135); distributions from Coverdell education savings accounts excludible under Sec. 530(d)(2); and amounts distributed from a qualified tuition program and excluded under Sec. 529(c)(3)(B).

Under Sec. 221(d)(1), QHEEs must be incurred by the taxpayer or his or her spouse or dependent at the time the debt is incurred. Such expenses must be attributable to education furnished during a period when the student qualified as an eligible student, and must be paid or incurred within a reasonable period before or after the debt is incurred, Regs. Sec. 1.2211(e)(3)(i)(B) identifies an eligible student as one who is a degree candidate carrying at least half a normal fulltime courseload.

Reasonable period: Regs. Sec. 1.221-1(e)(3)(ii) provides that a reasonable period is determined on the basis of doe relevant facts and circumstances; a safe harbor rule provides two ways in which expenses can be deemed paid within a reasonable time. The first is if they are paid with loan proceeds that are part of a Federal postsecondary education loan program; the second is if the proceeds used to pay expenses for a particular academic period are disbursed during a period that begins 90 days before the start of such academic period and ends 90 days after it ends.

Eligible educational institution: Regs. Sec. 1.221-1(e)(1) provides that an eligible educational institution can be any college, university, vocational school or other postsecondary educational institution described in Section 481 of the Higher Education Act of 1965 (20 USC Section 1088). The institution must be certified by the U.S. Department of Education as eligible to participate in the Department's student-aid programs. Certain institutions or healthcare facilities offering internship or residency programs are also eligible. An educational institution is required to be eligible only at the time the student is an eligible student. Regs. Sec. 1.221-1(e)(4), Example (5), clarifies that even if an eligible institution subsequently loses eligibility, the qualified education loans borrowed while the institution was eligible will continue to be qualified.

Other Requirements

To prevent a double benefit, Regs. Sec. 1.221-1(g)(2) prohibits a Sec. 221 deduction for any amount deducted under any other Code provision or for any amount excluded under Sec. 108(f) (related to debt cancellation). Regs. Sec. 1.221-1(b)(1) provides that to take the deduction, the taxpayer must have a legal obligation to make the interest payments. If a parent makes a payment on a loan for which only the child is liable, the parent is not entitled in a deduction.

Regs. Sec. 1.221-1(b)(2) limits the interest deduction to taxpayers who are not claimed as dependents during the year. If a taxpayer is claimed as someone else's dependent for the year, he or she may not claim a Sec. 221 deduction in that same year. Under Regs. Sec. 1.221-1(b)(3), married taxpayers may claim a Sec. 221 deduction only if they file jointly.

Deferment: For ninny student loans, interest payments are not required until after the student completes the schooling. Similarly, there may be periods when a borrower is not required to make payments on a student loan, such as a deferment on an undergraduate student loan during a period in which a student returned to school to obtain a graduate degree. Regs. Sec. 1.2211(g)(1) provides that interest payments on qualified student loans at such times are deductible.

Third-party payments: Regs. Sec. 1.221-1(b)(4) addresses interest payments by third parties. If a third party not legally obligated to pay interest, makes a payment for a taxpayer legally obligated to pay interest, the payment is treated as made from the third party to the taxpayer, and then from the taxpayer. In such cases, the taxpayer is entitled to an interest deduction if all the other Sec. 221 conditions are met. Examples include situations in which a third party pays the interest as a gift to the taxpayer or the taxpayer's employer pays the interest as taxable compensation to the taxpayer.

Income Phaseout 

Sec. 221(b)(2)(B) provides that the interest deduction is limited to $2,500 for 2001 and thereafter; the deduction is phased out for higher-income taxpayers. The deduction is not available for taxpayers with modified adjusted gross income (MAGI) (as defined in Sec. 221 (b)(2)(C)) of $65,000 or more ($130,000 on a joint return). The deduction starts to phase out proportionally as MAGI rises from $50,000 to $65,000 (from $100,000 to $130,000 on joint returns). After 2002, the phase-out range is adjusted for inflation in $5,000 increments, under Sec. 221(f).

MAGI is described in Regs. Sec. 1.221-1(d)(2). The computation starts with Sec. 62 AGI and takes into account (1) the exclusion of Social Security and railroad retirement benefits (Sec. 86), interest on the redemption of U.S. savings bonds used to pay higher education costs (Sec. 135) and amounts received under adoption assistance programs (See. 137); (2) the deduction for qualified retirement contributions (Sec. 219); and (3) the limit on the deduction for passive activity losses (See. 469). However, MAGI is computed without excluding income from foreign sources and certain possessions (Sec. 911, 931 or 933), and without deductions for qualified tuition (Sec. 222) or interest on qualified education loans (Sec. 221).

Deductible Interest

Regs. Sec. 1.221-1(f) provides that the interest eligible for deduction includes the amount stated as interest on the loan, plus any interest included as original issue discount (OLD). For this purpose, OID can include capitalized interest and loan origination fees.

Regs. Sec. 1.221-1(f)(1)(ii) defines capitalized interest as any unpaid accrued interest added by the lender to the amount of the loan (e.g., interest that accrued while the student was in school on a loan that did not have to be paid until after graduation). The lender capitalizes the unpaid interest and adds it to the amount borrowed. The unpaid interest included in the loan's outstanding balance is OID. Regs. Sec. 1.2211(f)(2)(i) provides that OID is not deductible as it accrues, but when paid. Thus, as the loan balance is paid, amounts attributable to capitalized interest are paid first; such payments are deductible as interest on a qualified education loan.

Loan Origination Fees

Regs. Sec. 1.221-1(f)(2)(ii) and (f)(4), Example (2), discuss loan origination fees. When the lender imposes such a fee, the amount is typically deducted from the loan proceeds. If the loan origination fee is imposed for the use of money (rather than for property or services), the fee creates or increases the OID on the loan. When the fee is imposed for the use of money, it is deemed interest that accrues over the loan's term. Each payment made on the loan first pays the stated interest, then pays any OID accrued as of the payment date, then pays principle. As the loan is paid, the loan origination fee is paid, and the interest is deductible.

Conclusion

Taxpayers who seek to deduct interest paid on education loans must meet Sec. 221's requirements. While the rules are relatively straightforward, the new regulations help clarify the gray areas.

FROM WAYNE M. SCHELL, PH.D., CPA, ASSOCIATE PROFESSOR, CHRISTOPHER NEWPORT UNIVERSITY, NEWPORT NEWS, VA (NOT AFFILIATED WITH DFK INTERNATIONAL)