Borrowers of qualified education loans may deduct up to $2,500 in interest on their federal income tax returns as an above-the-line exclusion from income. This includes interest paid on federal and private education loans.

Amount of the Deduction

You can deduct up to $2,500 in interest on a qualified education loan. The deduction is taken as an adjustment to income, so you can take the deduction even if you don't itemize deductions on Schedule A of your 1040.

Qualified Education Loans

The interest must have been paid on a qualified education loan for you, your spouse, or someone who was your dependent when the money was borrowed.

A qualified education loan is defined as a debt borrowed solely to pay qualified higher education expenses. Mixed-use loans do not qualify. This means that if the borrower refinances their education loans and receives cash out, interest on the new loan is no longer deductible. However, if the excess cash is only used to pay for higher education expenses, the interest on the new loan remains deductible.

Interest on private education loans qualifies, provided that the higher education expenses are attributable to a particular academic period and the disbursement used to pay for those expenses occured during the academic period or a 90-day window at the start and end of the academic period. Education loans do not need to be federally guaranteed to qualify. The debt, however, may not be owed to anybody who is related to the borrower.

According to regulations published by the IRS on May 7, 2004, education loan origination fees and capitalized interest qualify as deductible education loan interest. The amounts are amortized over the term of the loan (i.e., divide the capitalized interest by the number of years of the loan). Lenders will start reporting origination fees and capitalized interest for loans made on or after September 1, 2004. Students and parents can claim the deductions for past years by filing amended income tax returns.

Note that the borrower must have been legally obligated to make payments under the terms of the loan. This means that if the borrower voluntarily makes payments of interest during a period when such payments are not required, such as during a forbearance, deferment or grace period, that interest is not deductible. However, if the interest is required as part of the forbearance or deferment agreement, then the interest is deductible.

Eligible education expenses include tuition, fees, room and board, books, supplies, and equipment, transportation expenses, and other necessary expenses (as included in the school's student budget).

Additional Eligibility Restrictions

To take the deduction, you must not be claimed as an exemption on someone else's tax return.

The person for whom the expenses were incurred must have been enrolled at least half-time in a degree program.

The IRS regulations clarify that only the person legally obligated to repay the education loan may take the interest deduction. If someone else makes payments on a student's education loans, the student gets to take the deduction, not the other individual. For example, if a grandparent helps the student out with a few loan payments, the student takes the deduction, not the grandparent. These payments are treated as though they were first paid to the student, and then by the student to the lender.

Coordination Restrictions

You cannot take the deduction when the expenses were paid using certain tax-free education benefits, such as employer education assistance, tax-free withdrawals from a Coverdell Education Savings Account, US savings bond interest, veterans educational assistance benefits, and certain scholarships.

You cannot double-dip, meaning that if the interest is deductible elsewhere on the return (e.g., home mortgage interest), you cannot also deduct it as student loan interest.

Income Phaseouts

The deduction is phased out for taxpayers with adjusted gross incomes of $55,000 to $70,000 (single filers) and $115,000 to $145,000 (married filing jointly). (These are 2008 income phaseouts.)

Taxpayers who are married but filing separate returns are not eligible.

Parents who do not qualify because of the income phaseouts should consider having their child borrow the funds. Not only does the Stafford Loan have a lower interest rate than the PLUS loan, but the student is less likely to exceed the income phaseouts.