There are three things you can do with your student's Qualified educational expenses (QEE):
- Allocate then to scholarships (so that the scholarship remains tax free)
- Use them to claim an education credit
- Allocate them to the 529 distribution (1099-Q) so that it will not all be taxable
It does not matter what funds were used to pay what actual expenses. At tax time, you are free to allocate the expenses for the best outcome tax wise.* In particular, even though you used the 529 funds for loan payments, you don't have to treat it as such. You can allocate that distribution to room & board. That saves the limited student loan payment option for later. You do not have to report your any of your allocation to the IRS. You track it in your own records.
*An exception is if the scholarship is restricted to being used for tuition.
