Who can deduct the interest paid on a private student loan?

[QRFMTOA]

In 2021, my daughter, i.e., a dependent on my wife's and my joint return, took out a student loan from a commercial bank and her grandmother, i.e., my mother, or I was the cosigner.

Earlier this year, my mother paid the principal and interest directly to the lender in full, which I consider to be a gift to my daughter.

In TurboTax 2021, the following instructions were provided:

Student Loan Interest Deduction Worksheet

As long as your filing status is not married filing separately and you are not claimed as a dependent by someone else, you may be able to deduct up to $2,500 of qualified student loan interest you paid during 2021.

Qualified Student Loan

You, or your spouse if filing jointly, must be the person legally obligated to pay the loan, but the loan can be used to pay for your spouse's, your dependent's, or your own qualified education expenses. If you borrowed money from a relative to pay for education costs, or any of the loan was used for other purposes, or the loan was from a qualified employer plan, you cannot deduct any interest you paid on those loans.

In early 2024, my daughter should receive a 1098-E from the bank for the interest on the student loan.

Given the instructions provided by TurboTax 2021, will neither my daughter or I be able to deduct the interest paid?

Thanks!

QRFMTOA

[tagteam]

I'll page Champ @Hal_Al 

[Opus 17 · Accepted solution]

Your daughter can deduct the interest as if she paid it.  This is one of the few exceptions to the usual rule that a taxpayer can only deduct expenses that the taxpayer paid.  Publication 970 includes this:

Interest paid by others.

If you are the person legally obligated to make interest payments and someone else makes a payment of interest on your behalf, you are treated as receiving the payments from the other person and, in turn, paying the interest. https://www.irs.gov/publications/p970#en_US_2022_publink1000298880

Here, the "you" who is obligated to make payments is your daughter.

You (mother) can't deduct the interest because you didn't pay it, and the grandmother can't deduct the interest because the student was not her tax dependent when the loan was taken out.  But the student can deduct the interest. 

[Hal_Al]

I agree with @Opus 17 's answer. 

[QRFMTOA]

@Hal_Al   @Opus 17 

The first instruction says...

As long as your filing status is not married filing separately and you are not claimed as a dependent by someone else, you may be able to deduct up to $2,500 of qualified student loan interest you paid during 2021.

If "you" is my daughter...

As long as [my daughter's] filing status is not married filing separately  (Her filing status is Single.) and [my daughter is] not claimed as a dependent by someone else, [my daughter] may be able to deduct up to $2,500 of qualified student loan interest [she] paid during 2021.

Although my daughter is being claimed as a dependent by my wife and I, can my daughter still deduct the interest?

Thanks, again!

QRFMTOA

[Opus 17]

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@QRFMTOA wrote:

@Hal_Al   @Opus 17 

Although my daughter is being claimed as a dependent by my wife and I, can my daughter still deduct the interest?

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Ah, yes, that may be a problem.  The year in question is 2023, not 2021, since the loan interest was paid in 2023.  If your daughter is claimed as your dependent on your 2023 tax return, she can't deduct the student loan interest that was paid on her behalf, and therefore no one can.

Note, your daughter is asked two questions on her tax return.  First, "Can you be claimed as a dependent by someone else?"  Second, "Will the person who could claim you, actually claim you this year?"  If she qualifies to be claimed as a dependent, she must answer Yes to the first question, even if she answers No to the second question. 

If your daughter qualifies to be claimed as a dependent but you don't claim her, you lose a $500 credit.

If her income is less than $13,850, the deduction will not save her anything even if she is allowed to take it.  If her income is between $13,850 and $58,575, the deduction will save her 10% or 12% of the amount of interest that was paid for her.  Even at the maximum interest deduction of $2500, she would save no more than $300, against the $500 credit you lose.  Only if her income is more than $58,575 will she save more by deducting the interest than you will lose in credits.

Also, whether or not you claim your daughter affects who gets the American Opportunity Credit, you or her.  And depending on her income, she may get less AOTC on her own return than you would if you claimed her.  

The only way to know for sure is to test different scenarios.  But it seems likely that, if she is still your dependent, then no one claims the student loan interest deduction for the amounts the grandmother paid off.  It's just a wonderful gift, but with no additional tax benefits.  

[QRFMTOA]

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@Opus 17 wrote:

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@QRFMTOA wrote:

@Hal_Al   @Opus 17 

Although my daughter is being claimed as a dependent by my wife and I, can my daughter still deduct the interest?

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Ah, yes, that may be a problem.  The year in question is 2023, not 2021, since the loan interest was paid in 2023.  If your daughter is claimed as your dependent on your 2023 tax return, she can't deduct the student loan interest that was paid on her behalf, and therefore no one can.

Note, your daughter is asked two questions on her tax return.  First, "Can you be claimed as a dependent by someone else?"  Second, "Will the person who could claim you, actually claim you this year?"  If she qualifies to be claimed as a dependent, she must answer Yes to the first question, even if she answers No to the second question. 

If your daughter qualifies to be claimed as a dependent but you don't claim her, you lose a $500 credit.

If her income is less than $13,850, the deduction will not save her anything even if she is allowed to take it.  If her income is between $13,850 and $58,575, the deduction will save her 10% or 12% of the amount of interest that was paid for her.  Even at the maximum interest deduction of $2500, she would save no more than $300, against the $500 credit you lose.  Only if her income is more than $58,575 will she save more by deducting the interest than you will lose in credits.

Also, whether or not you claim your daughter affects who gets the American Opportunity Credit, you or her.  And depending on her income, she may get less AOTC on her own return than you would if you claimed her.  

The only way to know for sure is to test different scenarios.  But it seems likely that, if she is still your dependent, then no one claims the student loan interest deduction for the amounts the grandmother paid off.  It's just a wonderful gift, but with no additional tax benefits.  

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cc: @Hal_Al 

Dear @Opus 17,

Everything you said in your first response to my question was true because your intuition about my daughter's dependency status was correct, i.e., she was not my wife's and my dependent in 2023, and because you are detailed and thorough, everything you said above is also true despite my confusing my daughter's dependency status in 2023.

For clarity's sake... In 2021, my daughter was my wife's and my dependent; however, in 2023, she was 23 and a full-time graduate student for the Spring semester, but she was responsible for more than half of her support  in 2023 (and had a gross income greater than $20,000). 

Thanks, again, for keeping me straight!

QRFMTOA

[Opus 17]

@QRFMTOA 

Then we have covered everything?  If the grandmother paid the interest in 2023, and the student is not your dependent for 2023, then the student can deduct the interest as if she had paid it herself.