You son does NOT need to file a tax return if the $3000 of scholarship income is his only income. Although taxable scholarship is unearned income, for purposes of calculating a dependent's standard deduction, it is treated as earned income. Another way of saying that is, scholarship income is not subject to the $1100 filing threshold, it falls under the $12,400 filing threshold.
Q. 1. Is including the 1098-T on both returns a valid approach?
A 1.. Yes
Q. 2. Am I really allowed to get refunded for the $1,740 out-of-pocket qualified expenses under the American Opportunity Credit even if my son has unearned income to report from the scholarships/grants received?
A. 2. Yes and it gets better. You are allowed to claim even more and get the maximum $2500 American Opportunity Credit. See details below*.
Q. 3. If Turbotax states that my son has no tax due after reporting the 1098-T and 8615, does he still need to file? -
A. 3. No. As stated before, it's the $12,400 threshold that applies, not $1100.
Q. 4. This approach has allowed me to maximize my return by getting refunded for the $1,740 in expenses, while my son is simultaneously avoiding tax due on the unearned income from the 1098-T. Is this legitimate and should I be concerned that the IRS might flag either my, or my sons return?
A. 4. Yes, very legitimate and even quoted in IRS publications. See below*.
*There is a tax “loophole” available. The student reports all his scholarship, up to the amount needed to claim the American opportunity credit, 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 $7000 in box 1. At first glance he/she has $3000 of taxable income and nobody can claim the American opportunity credit. But if she reports $7000 as income on her return, the parents can claim $4000 of qualified expenses on their return.
Adding your $1740 of out of pocket expenses to the example; the student only reports $5260 as income.
This is not some sinister scheme. From the 2019 form 1040 instructions (pg 95): “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, line 18c, and IRS.gov/EdCredit. Page 16 of PUB 970 (2019) actually has examples of how to do the “loop hole”.
