Joe’s dependent daughter, Leah, is a sophomore in college. Leah’s scholarships cover all of her qualified education expenses, and they are tax-free. When Joe filed his taxes this year, he skipped over the part about education credits because logic told him, “You can’t get an education tax credit for something you didn’t pay for.” But assumptions about taxes based on logic are often faulty and, in this case, the mistake could cost Joe as much as $10,000 over the four-year period his daughter spends earning her undergraduate degree if he is eligible for the American Opportunity Credit.
While it is true that, as a general rule, you must reduce qualified education expenses by the amount of any scholarships or grants when determining an education tax credit, there is one exception to this rule: If the terms of the scholarship are “unrestricted,” it may be possible to claim an education credit even if all of the qualified education expenses are paid for with a scholarship or grant.
For this purpose, unrestricted terms means that the money received can be used to pay any type of education expenses, including non-qualified expenses, such as room and board. The recipient of the scholarship or grant can elect to apply the scholarship money to non-qualified education expenses. This then results in no reduction in qualified education expenses for calculating the education credit, up to the amount applied to non-qualified expenses.
Keep in mind that if Leah has an unrestricted scholarship, the amount applied to non-qualified education expenses will now be considered taxable income to her. Whether or not Leah will need to file a tax return will depend on her other income and whether she is eligible for a refund, etc. It may be a good idea for her to file a return even if she does not have a filing requirement. This way, she will be on record as having reported the income while also verifying Joe’s eligibility to claim the credit.
So what should Joe do now that he knows about the exception? First, he should review the terms of the scholarship to see if it has unrestricted terms – one common example of an unrestricted grant is a Pell Grant. Before amending his return and claiming a tax credit, Joe should recalculate both his own tax return (with the education credit added) and Leah’s tax return (with the income added) and determine which scenario is most tax beneficial for the household.
It may turn out that reducing qualified education expenses by the amount of the scholarship leads to a better result than including the scholarship as taxable income on Lea’s tax return. Whatever the outcome, Joe can now rest easy knowing he has explored every possibility for reducing his taxes.