Q. Is this reality or am I doing something wrong?
A. This is reality.
If this is her last year and you're just finding it out, it means she did it wrong for the last three years. Amended returns are probably required and she owes back taxes. But there is also good news. There is a tax loop hole available where the parents of students on scholarship can claim a $2500 tuition credit if the student pays just a little more tax (the family comes out $2000+ ahead). See below the line. They should file amended returns to get the other $7500. The deadline for filing 2021 amended returns is 4-15-25.
Also, scholarships are a hybrid between earned and unearned income. It is earned income for purposes of the $14,600 filing requirement (2024) and the dependent standard deduction calculation (earned income + $450 up to $14,600 max). It is not earned income for the "kiddie tax" (taxed at the parent's rate) and other purposes (e.g. EIC). For grad students and post grad fellows, scholarship, stipend and fellowship income is earned income ("compensation") for IRA contributions.
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There is a tax “loop hole” available to claim an education credit, for the parents of students on scholarship. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), as income on his return. That way, the parents (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship. You cannot do this if the conditions of the grant are that it be used to pay for qualified expenses.
Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he/she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000 of qualified expenses on their return.
Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials, paid out of pocket. She would only need to report $5000 of taxable scholarship income, instead of $6000.
The IRS actually encourages use of this technique. From the form 1040 instructions: “You may be able to increase an education credit if the student chooses to include all or part of a Pell grant or certain other scholarships or fellowships in income. For more information, see Pub. 970, the instructions for Form 1040 and IRS.gov/EdCredit". PUB 970 even has examples of how to do the “loop hole”.
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