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So let me get this straight - you can deduct ALL interest - whether you physically pay for it or not?

Meaning, if you are on forebearance or deferment - and they capitalize the interest, you do not make an interest payment - but you can still deduct the interest?


You get to deduct student loan interest you pay. This can be either come up with cash out of your pocket, checking account, etc., or money that comes from another loan that pays off the interest. (This is what you mean by "physically pay", right?)

If you are on forbearance (deferment, etc.), the interest that you don't pay sits there, or even capitalizes, but remains interest. However and unfortunately, until you pay on it, you can't deduct it.

I thought the original question was more along the lines that interest had accrued in 1999, 2000, 2001 etc., and sat in the account as "capitalized interest". Then, it got paid, in whole or in part, in 2002. THAT interest is deductible, (up to the $2500 limit and respecting the AGI caps and phaseouts.)

In Lady I's situation, what happened is Direct Loans came to Sallie with a check (the thing Sallie dreads) and paid off the whole loan (principal plus outstanding interest). So this represents a payment of interest (the outstanding interest was paid). $2500 of it should be eligible for a deduction on the 2002 return. Just because it was borrowed money that paid it off doesn't matter.

If interest just grows and sits there, and you don't pay anything on it, then you're out of luck.

(But one good strategy, if you have income that fluctuates and a loan on "ice", is to try and make the payments on interest in the years when you know you'll have the deduction.)
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