It takes $4000 of qualified expenses to get the maximum $2500 American Opportunity Credit (AOC). The AOC is 100% of the first $2000 of qualified expenses and 25% of the next $2000.
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 full American Opportunity Credit, as income on his return. That way, the parents (or himself, if he is not a dependent) can claim the full 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 conditions of the grant are that it be used to pay for qualified expenses.
Using an example: Student has $5,000 in box 5 of the 1098-T and $8000 in box 1. At first glance you only have $3000 of net qualified expenses to claim the AOC. But if the student reports $1000 as income on her return, the parents can claim $4000 of qualified expenses on their return.
Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $500 in expenses for those course materials, paid out of pocket. She would only need to report $500 of taxable scholarship income, instead of $1000.*
The IRS actually encourages use of this technique. From the form 1040 instructions: “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 and IRS.gov/EdCredit". PUB 970 even has examples of how to do the “loop hole”.
*If the student has no other income (and/or only has wage income), there will be no tax until the total income is more than $14,600. Investment income is taxed differently.
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