Scholarships that pay for qualified educational expenses (QEE - tuition, fees, books and other course materials, including a computer) is tax free. Scholarship amounts that exceed QEE is taxable income, on the student’s tax return.
If box 5 of the 1098-T exceeds box 1, TurboTax (TT) will treat the difference as taxable income, unless you enter additional QEE at books and other expenses. Room and board are not qualified expenses for tax free scholarship.
At tax filing time, you may allocate expenses, as needed, for best benefits. That is, you don't have to literally do an accounting of what money paid what expenses.
Furthermore, there is a tax “loop hole” available to claim an education credit, for the parents of students on scholarship. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), 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 (example 1): Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he/she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000 of qualified expenses on their return.
(Example 2): Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials, paid out of pocket, she would only need to report $5000 of taxable scholarship income, instead of $6000.
Q. How to enter all that in TurboTax (TT)?
A. Very carefully, the TT interview can theoretically handle this, but it gets complicated. Better yet, use a short cut.
In example 2, the parents would enter the 1098-T, on their return, with $4000 in box 1 and box 5 blank. The student would enter the the 1098-T, on her return, with box 1 blank and $5000 in box 5.
For more specific help, provide actual numbers. If you also have a 529 plan, advise us of any distributions.
