1) Given the information above, are we eligible to reduce taxes by including the scholarship amount shown?
Showing the scholarship as "Tax free assistance" at the screen where you enter the expenses will help reduce the penalty for a non qualified distribution (the scholarship exception). The distribution and scholarship must be in the same year.
2) After it Returns to "Form 1099-Q Summary" screen, press done, you'll get more questions and the expenses screen.
3) Regarding the Earnings shown in Box 2 of the 1099-Q, why is this taxed as ordinary income and not included in Capital Gains since this is from investment income?
Because Congress said so. The same argument could be made IRAs and 401k accounts. You can not use your capital losses to offset the taxable portion of the 529 distribution.
You say "The distribution was not used for college expenses". Yet, you indicate a 1098-T was received, showing tuition paid. To claim some of the distribution as qualified, you did not literally have to use it for expenses. The student only had to incur expenses, including room and board, in the same year as the distribution. If the 1098-T was for 2021 and the distribution was in 2022 that doesn't count.
