Since his ROOM was paid with these taxable funds, can I remove an equal amount from a 529 tax-free?
No, unless you return it to the 529 account within 60 days after the withdrawal.
It would seem to me that once the scholarship is taxable, it could be used for anything - beer, football tickets, car expenses, etc. not necessarily room & board
That's absolutely true. But sometimes the school will actually hold those funds instead of refunding them to the student. That's why, when your scholarships awarded in a tax year exceed the qualified expenses paid in that same tax year, the program will ask you if any or all of the excess was held by the school. If yes, then it's assumed the school will apply that 2020 excess to qualified expenses in 2021, and that amount held back by the school won't be treated as taxable income.
However, it's up to you to track that for 2021 tax reporting. That's because if say for example, the student drops out in 2021. Then the school would refund the excess to the student if the student dropped out for a qualified reason. That would then make it taxable in 2021.
As for the wording in pub 970 - while most things are crystal clear in their clarity, there are those things that are open to interpretation. So while the document is "good" at covering everything, it's not what I would call "stellar" at explaining it with clarity.
