Q. How to generate an American Opportunity Tax Credit by declaring $4,000 of 529 money as taxable?
A. With your numbers, you don't want to do that (allocate expenses away from the 529 to the AOTC).
Instead, you allocate expenses away from the scholarship and to the AOTC. And, that is what TurboTax (TT) has correctly (apparently) done. That's why you have $4000 of taxable scholarship income on line 8r of schedule 1.
You must allocate all room & board (R&B) expenses to the 529 distribution. R&B is a qualified expense for a 529 distribution, but not for tax free scholarship and AOTC.
$19,866 in education expenses(including room & board)
-$6,066 paid by tax free scholarship
-4,000 used to claim the AOTC
$9,800 can be used against the 1099-Q
So the 1099-Q is tax free. If TT did it right, there should be no entry on line 8z of schedule1 (that's where taxable 529 earnings go). You should be showing the AOTC on line 3 of schedule 3 ($1500 max) and line 29 of form 1040 ($1000).
