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[[Can someone please explain how the deduction on the interest of a student loan works? I have paid
three and a half years on my loan. I am hearing that you can take a deduction on the first five years
of the loan. Is this a percentage of the interest or can you deduct all of it in the year that it was paid?
When did this deduction start? ]]

This may help...

There is a new interest deduction in town which was recently introduced by the 1997 Taxpayer Relief Act: interest on qualified education loans. The deduction applies to interest due and paid after 1997 on loans taken out on, before, or after Aug. 5, 1997. This being the case, you may qualify for this deduction for interest you pay after 1997 on existing loans. (But you can't take a deduction for interest due after 1997 that you pay in advance in 1997.)

The deduction is a much different from the general rule that interest on "personal" loans isn't deductible (except, in most cases, for mortgage interest on your home). Here are the requirements for deductibility: The maximum amount of interest you can deduct is $1,000 in 1998, $1,500 in 1999, $2,000 in 2000, and $2,500 in 2001 or later. The maximum isn't adjusted for inflation. However, the deductible amount is reduced for certain high Adjusted Gross Income (AGI) taxpayers. We'll deal with those restrictions below.

The interest must be for a "qualified education loan," i.e., for a debt incurred to pay tuition, room and board, and related expenses to attend a post-high school educational institution, including certain vocational schools. Certain post-graduate programs also qualify. Thus, an internship or residency program leading to a degree or certificate awarded by an institution of higher education, hospital, or health care facility offering post-graduate training can qualify.

But note: Only interest paid during the first 60 months that payments are required can qualify. Months in which payments aren't required, e.g., during a deferral or forbearance period, aren't counted against the 60-month period. In the case of an already existing loan, interest payments qualify for the deduction to the extent that the 60-month period has not yet expired. But months during which interest was paid before Jan. 1, 1998 would count against the 60-month period. For this purpose, a loan and all refinancings of the loan are treated as a single loan.

Income Limitations: The deduction is only fully allowed for taxpayers (married filing jointly) with Adjusted Gross Income (AGI) of $60,000 or less. For taxpayers with AGI of $75,000 or more, no deduction is allowed. If AGI is between $60,000 and $75,000 the deduction is partially reduced, depending on how far above $60,000 the taxpayer's AGI happens to be. Example: if AGI is $65,000, the deduction is reduced by 33 1/3% since the $5,000 excess above $15,000 represents 33 1/3% of the $15,000 excess that would result in complete disallowance.

For other taxpayers, e.g., single taxpayers, a full deduction is allowed if AGI is $40,000 or less, no deduction is allowed if AGI is $55,000 or more, and a similar partial disallowance approach is taken where AGI is between $40,000 and $55,000. (For these purposes, AGI is computed with certain modifications, e.g., the exclusion of income from U.S. savings bonds used to pay higher education costs isn't taken into account.) The $60,000 (and $40,000) "phase-out" amounts discussed above will be adjusted for inflation for years after the year 2002.

Married taxpayers must file jointly or no deduction is allowed. Also, no deduction is allowed by a taxpayer who can be claimed as a dependent on the tax return of someone else. Where a deduction is allowed, it is taken "above the line," i.e., it is subtracted from gross income to determine AGI. Because of this "above the line" treatment, the interest deduction can be used by everybody that qualifies for it, regardless of if deductions are itemized or not.

There are other requirements: The interest must be on funds borrowed to cover qualified education costs of the taxpayer or his spouse or dependent. The expenses must be for education furnished while the recipient was an "eligible student," i.e., at least a half-time student. Also, the education expenses must be paid or incurred within a reasonable time before or after the loan is taken out.

But there are some further examples and illustrations that might help your understanding.

First, remember that the person must be your dependent when the loan is made, but there are no similar provisions when the loan is paid. For example, say that you took out a loan to pay for your daughter Sally's qualified education. Sally was your dependent at the time that you took out the loan, but has since graduated, is working, and is no longer your dependent. You can still deduct the interest that you pay on the loan (assuming that you otherwise qualify to do so) because Sally was your dependent when you made the loan.

Let's also take a closer look at the 60-month rule. While you can only deduct higher education interest during the first 60 months in which interest payments are required, those 60 months don't have to be consecutive. And months in which the loan is in deferral don't count against the 60-month period. For example, after paying interest on a college loan for 25 months, you decide to go back to school. Under the terms of the loan, payments are deferred during the time you are in school. When you resume making loan payments after your schooling ends, you will still have 35 months of deductible interest remaining.

But remember that if you refinance a loan, the months that have elapsed on the original loan are carried over to the new loan. For example, lets say that you have been paying off your qualified loan for the last 20 months, and you decide to refinance to take advantage of a lower interest rate. While the refinanced loan is "new", it is treated as a continuation of the original loan. This being the case, you will have only 40 months of remaining deductible interest.

And finally, remember that if you already have a higher education loan outstanding, you may STILL be able to deduct up to 60 months of interest, depending upon when the loan payment began. In some cases, interest payments on loans taken out may years ago will still be deductible in 1998. Example: you began paying off a higher education loan in July, 1994, 42 months before January, 1998 when the interest deduction takes effect. You will still be able to deduct a full 12 months of interest in 1998, and another 6 months in 1999 before your 60-month period expires.

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