Scholarships that paid for non qualified expenses (e.g. room & board) are taxable. Tuition, fees, books and computers are qualified expenses. If box 5 of your 1098-T is more than box 1, TurboTax will automatically treat the difference as taxable scholarship income unless you tell it differently.
Whatever amount is taxable on the federal return is also taxable on the state return. In TurboTax, the taxable amount automatically transfers to the state return.
You may actually want to make more of your student's scholarship taxable.
There is a tax “loop hole” available. 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 school’s billing statement specifically shows the scholarships being applied to tuition or 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.
