Sunday, February 25, 2007

Deduct "Hidden" Student Loan Interest

If you have student loans, or parent loans, you probably know the interest is generally tax-deductible, up to a maximum of $2,500 a year depending on income. The lender (or their servicing agent) sends you a Form 1098-E telling you how much interest you paid; and as long as you meet the requirements, you can deduct this amount.

Except you might not get this form, and even if you do, it may not show the complete deductible amount! There are three areas you need to check to find "hidden" interest.

1. According to the form itself, the lender is only required to send it if you paid at least $600 in interest for the year in question. So if you're under that threshold, you may have to calculate the interest yourself, based on the various statements the lender send you throughout the year, and/or your account and payment information on the lender's website.

It gets better. Form 1098-E shows only the interest you physically paid the lender during the year. But according to the IRS rules in Publication 970, Tax Benefits for Education, you may be able to deduct more than this.

2. Loan origination fees count as interest also. Publication 970 says if it's not on Form 1098-D, "you can use any reasonable method to allocate the loan origination fees over the term of the loan." So you can't deduct it all at once, but you have to spread it out.

3. Capitalized interest is deductible as well. This is interest that adds up while you aren't making payments, and which is added to the loan balance. Once you start making payments, you can take the deduction by essentially treating the entire payment amounts as interest until all the capitalized interest is paid off. See Publication 970 for all the details of the calculation you have to use. A spreadsheet will be very helpful in tracking the numbers.

So make sure you get all the student loan interest deduction to which you're entitled.

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