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February 5, 2006 -- My daughter started college last year and received a partial scholarship. What can I deduct on my 2005 tax return?

Tuition tax credits. You can take a Hope tax credit of up to $1,500 a year (for 2005) per student for the first two years of college (a 100% credit for the first $1,000 in tuition and a 50% credit for the second $1,000). You can take a Lifetime Learning credit of up to $2,000 per family for every additional year of college or graduate school (a 20% credit for up to $10,000 in tuition). Both credits are phased out for 2005 for couples with incomes between $87,000 and $107,000 (or singles with income between $43,000 and $53,000). Only one credit can be claimed for the same student in any given year. However, a taxpayer is allowed to claim a Hope or a Lifetime Learning credit for a tax year and to exclude from gross income amounts distributed (both the principal and the earnings portions) from a Coverdell education savings account for the same student, as long as the distribution isn't used for the same educational expenses for which a credit was claimed.

Deduction for college costs. Through 2005, certain taxpayers are permitted to take an above-the-line deduction for college tuition and related expenses that they pay. (An above-the-line deduction is more favorable than a below-the-line deduction because it may be taken regardless of whether the taxpayer elects to take the standard deduction or to itemize deductions, and it's not subject to the overall limitation on itemized deductions or to the 2% floor on miscellaneous itemized deductions.) In 2005, for taxpayers with AGI of up to $65,000 for singles and $130,000 for joint return filers, the maximum deduction is $4,000. Taxpayers with AGI over $65,000 ($130,000 for joint return filers), but not over $80,000 ($160,000 for joint return filers) may only take a $2,000 deduction. Taxpayers with AGI over $80,000 ($160,000 for joint return filers) get no deduction.

Scholarships. Scholarships are exempt from income tax. For this exemption to apply, certain conditions must be satisfied. The most important are that the scholarship must not be compensation for services, and it must be used for tuition, fees, books, supplies and similar items (and not for room and board). (Although a scholarship is tax-free, it will reduce the amount of expenses that may be taken into account in computing the Hope and Lifetime Learning credits, above, and may therefore reduce or eliminate those credits.)

College expense payments by grandparents and others. If someone other than you pays your child's college expenses, the person making the payments is generally subject to the gift tax, to the extent the payments and other gifts to the child by that person exceed the regular annual (per donee) gift tax exclusion of $11,000 ($22,000 in the case of married donors who consent to split gifts) for 2005. If the other person pays your child's school tuition directly to an educational institution, however, there's an unlimited exclusion from the gift tax for the payment. The relationship between the person paying the tuition and the person on whose behalf the payments are made is irrelevant, but the payer would typically be a grandparent. The unlimited gift tax exclusion applies only to direct tuition costs. There's no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc.

Student loans. You can deduct interest on loans used to pay for your child's education at a post-secondary school, including some vocational and graduate schools. (This is an exception to the general rule that interest on student loans is personal interest and, therefore, not deductible.) The deduction is an above-the-line deduction (meaning that it's available even to taxpayers who don't itemize). The maximum deduction is $2,500. However, in 2005 the deduction phases out for taxpayers who are married filing jointly with AGI between $105,000 and $135,000 (between $50,000 and $65,000 for single filers). The phaseout amounts are adjusted annually for inflation.

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