the remaining $500 is credited at a 25% rate, so I actually need to have $4,000 in out of pocket to claim the full $2,500 in AOC. Is that not right?
Half right. The first $2000 is dollar for dollar, the next $2000 is 25%, up to $500. So, it takes $4000 out of pocket expenses to get the full $26500 AOC credit.
So, it's $4000 that would not be qualified*. But the full $4000 isn't taxable; only the ratio of earnings to distribution x $4000. See example above.
*Apply the $4000 to room and board to make it qualified. Room & board is not a qualified expense for a tuition credit, but it is for a 529 distribution.
