Education Tax Credits

The following two tax credits are available to persons who pay higher education costs.

• The Hope credit.
• The lifetime learning credit.

Table 36-1 compares the Hope and lifetime learning credits. If you are eligible to claim both credits based on the higher education expenses of one student, it will generally be to your benefit to claim the Hope credit.

Table 36-1. Comparison of Education Credits

If a student receives a tax-free withdrawal from an education IRA in a particular tax year, none of that student's expenses can be used as the basis of a higher education credit for that tax year. However, the student can waive the tax-free treatment. See Waiver of tax-free treatment under No double benefit allowed.

Rules That Apply to Both Credits

The amount of each credit is determined by the amount you pay for qualified tuition and related expenses for students and the amount of your modified adjusted gross income. Education credits are subtracted from your tax but they are nonrefundable. This means if the credits are more than your tax, the excess is not refunded to you.

If you are married filing separately you cannot claim the higher education credits.

What expenses qualify. The credits are based on qualified tuition and related expenses you pay for yourself, your spouse, or a dependent for whom you claim an exemption on your tax return. Generally the credits are allowed for qualified tuition and related expenses paid for an academic period beginning in the same year as the year the payment is made (but see Prepaid expenses, later).

In general, qualified tuition and related expenses are tuition and fees required for enrollment or attendance at an eligible educational institution. Student-activity fees and fees for course-related books, supplies, and equipment are included in qualified tuition and related expenses only if the fees must be paid to the institution as a condition of enrollment or attendance.

Prepaid expenses. If you paid qualified tuition and related expenses in 2001 for an academic period that begins in the first three months of 2002, you can use the prepaid amount in figuring your credit.

For example, if you paid $2,000 in December 2001 for qualified tuition for the winter 2002 semester beginning in January 2002, you can use that $2,000 in figuring your 2001 credit.

Payments with borrowed funds. You can claim an education credit for qualified tuition and related expenses paid with the proceeds of a loan. You claim the credit in the year in which the expenses are paid, not in the year in which the loan is repaid.

Expenses that do not qualify. Qualified tuition and related expenses do not include the cost of:

• Insurance,
• Medical expenses (including student health fees),
• Room and board,
• Transportation, or
• Similar personal, living or family expenses.

This is true even if the fee must be paid to the institution as a condition of enrollment or attendance.

Qualified tuition and related expenses generally do not include expenses that relate to any course of instruction or other education that involves sports, games, or hobbies, or any noncredit course. However, if the course of instruction or other education is part of the student's degree program or, in the case of the lifetime learning credit, is taken by the student to acquire or improve job skills, these expenses can qualify.

Dependent for whom you claim an exemption. You claim an exemption for a dependent if you list his or her name on line 6c, Form 1040 (or Form 1040A). (See chapter 3 for details on exemptions for dependents.)

Eligible educational institution. An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited, public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution.

Academic period. An academic period includes a semester, trimester, quarter, or other period of study (such as a summer school session) as reasonably determined by an educational institution.

No double benefit allowed. You cannot:

• Deduct higher education expenses on your income tax return and also claim a Hope credit based on those same expenses,
• Claim a Hope credit and a lifetime learning credit based on the same qualified education expenses, or
• Claim a credit based on expenses paid with tax-free scholarship, grant, or employer-provided educational assistance. See Adjustments to qualified expenses, next.

Adjustments to qualified expenses. If you pay higher education expenses with certain tax-free funds, you cannot claim a credit for those amounts. You must reduce the qualified expenses by the amount of any tax-free educational assistance you received. Tax-free educational assistance could include:

• Scholarships,
• Pell grants,
• Employer-provided educational assistance,
• Veterans' educational assistance, and
• Any other nontaxable payments (other than gifts, bequests, or inheritances) received for education expenses.

Do not reduce the qualified expenses by amounts paid with the student's:

• Earnings,
• Loans,
• Gifts,
• Inheritances, and
• Personal savings.

Also, do not reduce the qualified expenses by any scholarship reported as income on the student's return or any scholarship which, by its terms, cannot be applied to qualified tuition and related expenses.

Waiver of tax-free treatment. The designated beneficiary of a Coverdell ESA (formerly known as an education IRA) can waive the tax-free treatment of the withdrawal and elect to pay any tax that would otherwise be owed on the withdrawal. The beneficiary or the beneficiary's parents may then be eligible to claim a Hope credit or lifetime learning credit for qualified higher education expenses paid in that tax year. See Coverdell ESAs in Publication 970.

Refunds. Qualified tuition and related expenses do not include expenses for which you receive a refund. If you paid expenses in 2001, and you received a refund of those expenses before you file your tax return for 2001, simply reduce the amount of the expenses by the amount of the refund received. If you receive the refund after you file your tax return, see When must the credit be repaid, next.

When must the credit be repaid? If, after you file your 2001 tax return, you receive tax-free educational assistance for, or a refund of, an expense you used to figure a higher education credit on that return, you may have to repay all or part of the credit. You must refigure your education credits as if the assistance or refund was received in 2001. Subtract the amount of the refigured credit from the amount of the credit you claimed. See the instructions for your 2001 tax return for information about how and where to report the repayment (recapture).

Who can claim the credit. If there are higher education costs for your dependent for a year, either you or your dependent, but not both of you, can claim a credit for that dependent's expenses for that year. If you claim an exemption for your dependent on your tax return, only you can claim a credit. If you do not claim an exemption for your dependent on your tax return, only your dependent can claim a credit.

Expenses paid by dependent. If you claim an exemption on your tax return for an eligible student who is your dependent, treat any expenses paid by the student as if you had paid them. Include these expenses when figuring the amount of your Hope or lifetime learning credit.

Qualified tuition and related expenses paid directly to an eligible educational institution for your dependent under a court-approved divorce decree are treated as paid by your dependent.

Expenses paid by others. If someone other than you, your spouse, or your dependent (such as a relative or former spouse) makes a payment directly to an eligible educational institution to pay for an eligible student's qualified tuition and related expenses, the student is treated as receiving the payment from the other person. The student is treated as paying the qualified tuition and related expenses to the institution. If you claim an exemption on your tax return for the student, you are considered to have paid the expenses.

Example. Ms. Allen makes a payment directly to an eligible educational institution in 2001 for her grandson Todd's qualified tuition and related expenses. For purposes of claiming an education credit, Todd is treated as receiving the money from Ms. Allen and, in turn, paying his qualified tuition and related expenses himself.

If Todd's exemption is not claimed on anyone's return, he can use the payment to claim an education credit.

If anyone, such as his parents, claims an exemption for him on their tax return, whoever lists him as a dependent may be able to use the expenses to claim an education credit.

Nonresident alien. You cannot claim an education credit if you (or your spouse) were a nonresident alien for any part of 2001, and the nonresident alien did not elect to be treated as a resident alien. More information on nonresident aliens can be found in Publication 519, Tax Guide for U.S. Aliens.

Does the Amount of Your Income Affect the Amount of Your Credit?

Your education credits are phased out (gradually reduced) if your modified adjusted gross income is between $40,000 and $50,000 ($80,000 and $100,000 if you file a joint return). You cannot claim any higher education credits if your modified adjusted gross income is $50,000 or more ($100,000 or more if you file a joint return).

How the phaseout works. The phaseout (reduction) works on a sliding scale. The higher your modified adjusted gross income, the more your credits are reduced. You figure the reduction, if any, in Part III of Form 8863.

Modified adjusted gross income. For most taxpayers, modified adjusted gross income (MAGI) will be their adjusted gross income (AGI) as figured on their federal income tax return.

On Form 1040, AGI is line 34. On Form 1040A, AGI is line 19.

However, you must file using Form 1040 and make adjustments to your AGI if you excluded income earned abroad or from certain U.S. territories or possessions.

If this applies to you, increase your AGI by the following amounts you excluded from your income.

1. Foreign earned income of U.S. citizens or residents living abroad.
2. Housing costs of U.S. citizens or residents living abroad.
3. Income from sources within Puerto Rico, Guam, American Samoa, or the Northern Mariana Islands.

At present, no implementation agreement has been signed with Guam or the Northern Marianna Islands to allow exclusion of income from those sources. Until an implementation agreement is signed, there is no exclusion from these sources which must be added to your AGI to determine MAGI.

Hope Credit

You may be able to claim a Hope credit of up to $1,500 for qualified tuition and related expenses paid for each eligible student.

Eligible student for the Hope credit. For purposes of the Hope credit an eligible student is a student who meets all of the following requirements.

1. Did not have expenses that were used to figure a Hope credit in any 2 earlier years.
2. Had not completed the first 2 years of postsecondary education (generally, the freshman and sophomore years of college).
3. Was enrolled at least half-time in a program that leads to a degree, certificate, or other recognized educational credential, for at least one academic period beginning in 2001.
4. Was free of any federal or state felony conviction for possessing or distributing a controlled substance as of the end of 2001.

Completion of first 2 years. A student who was awarded 2 years of academic credit for postsecondary work completed before 2001 has completed the first 2 years of postsecondary education. This student would not be an eligible student for purposes of the Hope credit.

Any academic credit awarded solely on the basis of the student's performance on proficiency examinations is disregarded in determining whether the student has completed 2 years of postsecondary education.

Enrolled at least half-time. A student was enrolled at least half-time if the student was taking at least half the normal full-time work load for his or her course of study.

The standard for what is half of the normal full-time work load is determined by each eligible educational institution. However, the standards may not be lower than those established by the Department of Education under the Higher Education Act of 1965.

Amount of credit. The amount of the Hope credit is the sum of:

1. 100% of the first $1,000 qualified tuition and related expenses you paid for each eligible student, and
2. 50% of the next $1,000 qualified tuition and related expenses you paid for each eligible student.

The maximum amount of Hope credit you can claim in 2001 is $1,500 times the number of eligible students. You can claim the full $1,500 for each eligible student for whom you paid at least $2,000 of qualified expenses. However, the credit may be reduced based on your modified adjusted gross income. See Does the Amount of Your Income Affect the Amount of Your Credit?, earlier.

Example. Jon and Karen are married and file a joint tax return. For 2001, they claim an exemption for their dependent daughter on their tax return and their modified adjusted gross income is $70,000. Their daughter is in her sophomore (second) year of studies at the local university and Jon and Karen pay qualified tuition and related expenses of $4,300 in 2001.

Jon and Karen, their daughter, and the local university meet all of the requirements for the Hope credit. Jon and Karen can claim a $1,500 Hope credit in 2001. This is 100% of the first $1,000 qualified tuition and related expenses, plus 50% of the next $1,000.

How to figure the Hope credit. The Hope credit is figured in Parts I and III of Form 8863. An illustrated example using Form 8863 appears later.

Lifetime Learning Credit

You may be able to claim a lifetime learning credit of up to $1,000 for qualified tuition and related expenses paid for all students enrolled in eligible educational institutions.

The lifetime learning credit is different than the Hope credit in the following ways.

1. The lifetime learning credit is not based on the student's work load. It is allowed for one or more courses.
2. Expenses for graduate-level degree work are eligible.
3. Expenses related to a course of instruction or other education that involves sports, games, hobbies, or other noncredit courses are eligible if they are part of a course of instruction to acquire or improve job skills.
4. There is no limit on the number of years for which the lifetime learning credit can be claimed for each student. It is not limited to students in the first 2 years of postsecondary education.
5. The amount you can claim as a lifetime learning credit does not vary (increase) based on the number of students for whom you pay qualified expenses.

Amount of credit. The amount of the lifetime learning credit is 20% of the first $5,000 qualified tuition and related expenses you pay for all eligible students. The maximum amount of lifetime learning credit you can claim for 2001 is $1,000 (20% � $5,000). However, that amount may be reduced based on your modified adjusted gross income. See Does the Amount of Your Income Affect the Amount of Your Credit, earlier.

Example. Bruce and Toni are married and file a joint tax return. For 2001, their modified adjusted gross income is $50,000. Toni is attending the community college (an eligible educational institution) to earn credits towards an associate's degree in nursing. She already has a bachelor's degree in history and wants to become a nurse. In August 2001, Toni paid $4,000 for her fall 2001 semester. Bruce and Toni can claim an $800 (20% � $4,000) lifetime learning credit on their 2001 joint tax return.

How to figure the lifetime learning credit. The lifetime learning credit is figured in Parts II and III of Form 8863. An illustrated example using Form 8863 appears later.

Choosing Which Credit To Claim

For each student, you can elect for any tax year only one of the credits or a tax-free withdrawal from a Coverdell ESA. (See Coverdell ESAs in chapter 4, Publication 970, for more information.)

For example, if you elect to take the Hope credit for a child on your 2001 tax return, you cannot, for that same child, also claim the lifetime learning credit for 2001 or take a tax-free withdrawal from a Coverdell ESA for 2001.

Lifetime learning credit after Hope credit. You can claim the Hope credit for the first 2 years of a student's postsecondary education and claim the lifetime learning credit for that same student in later tax years.

Tax credits for more than one student. If you pay qualified expenses for more than one student in the same year, you can choose to take credits on a per-student, per-year basis. This means that, for example, you can claim the Hope credit for one student and the lifetime learning credit for another student in the same tax year.

How Is the Credit Claimed?

You elect to claim education credits and you figure their amount by completing Form 8863. A filled-in Form 8863 is shown in the Illustrated Example at the end of this chapter.

An eligible educational institution (such as a college or university) that received payment of qualified tuition and related expenses in 2001, generally must issue Form 1098-T, Tuition Payments Statement, to each student by February 1, 2002. The eligible educational institution may ask for a completed Form W-9S, Request for Student's or Borrower's Social Security Number and Certification, or similar statement, to obtain the student's name, address, and taxpayer identification number.

Illustrated Example

Dave and Valerie are married and file a joint tax return. For 2001, they claim exemptions for their two dependent children on their tax return. Their modified adjusted gross income is $72,000. Their tax is $9,475. Their son, Sean, will receive his bachelor's degree in psychology from the state college in May 2002. Their daughter, Corey, enrolled full-time at that same college in August 2000 to begin working on her bachelor's degree in physical education. In December 2000, Dave and Valerie paid $2,000 for each child's tuition for the winter 2001 semester. In July 2001, they paid $2,200 in tuition costs for each of them for the fall 2001 semester.

Form 8863 for Dave and Valerie

Dave and Valerie, their children, and the college meet all of the requirements for the higher education credits. Because Sean is beyond the second (sophomore) year of his postsecondary education, his expenses do not qualify for the Hope credit. But, amounts paid for Sean's expenses in 2001 for academic periods after 2000 and before April 1, 2002, qualify for the lifetime learning credit. Corey is in her first (freshman) year of postsecondary education and expenses paid for her in 2001 for academic periods beginning after 2000 and before April 1, 2002, qualify for the Hope credit.

Dave and Valerie figure their total higher education credits for 2001, $1,940, as shown in the completed Form 8863. They can claim the full amount because their modified adjusted gross income is not more than $80,000. They carry the amount from Form 8863 to line 46 of Form 1040, and they attach the Form 8863 to their return.

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