Explaining the American Opportunity Tax Credit

When I talk to a taxpayer about their return and the potential of claiming the American Opportunity Tax Credit (AOTC) they often are confused about it, especially if the AOTC involves including scholarships in income. I've struggled with how to explain it and continually expand or contract the explanation depending on how much I think they understand. In cases where the student and parent must coordinate their returns to get the biggest credit the explanation is even more critical since it must be relayed to the other person.

This is my effort to outline the basics of the AOTC in an orderly and progressive way. The actual rules are more complex but this should help taxpayers understand what is happening. The first 5 include the basics. The second half deals with scholarships mixed in.

1

The American Opportunity Tax Credit (AOTC) is available for the first $4,000 of qualifying educational expenses.  The credit amount is calculated at 100% of the first $2,000 and 25% of the next $2,000.

2

Only 40% of the credit is refundable (max $1,000), and there are separate qualifying rules for the refundable part. The rest of it can only reduce the amount of tax paid.

3

Amounts paid in cash, credit, loans, or by third-parties are included in qualifying expenses. The amounts may be reported on a 1098T but the taxpayer may need to verify the amounts with the student’s financial account. A 1098T is not required.

4

Qualifying expenses are amounts paid for tuition, books, and related expenses. Other expenses such as room and board don't count as qualifying expenses.

5

The AOTC is claimed on the return for which the student is being claimed as a dependent. If the student is claimed as a dependent on someone else's return the student cannot claim the AOTC.

6

If you receive scholarships that cover some of your expenses, they reduce the total amount of qualifying expenses.

Example 1: If you have qualifying expenses of $3,000 and scholarships of $2,000, the net amount of qualifying expenses available for claiming the AOTC is $1,000.

7

If your scholarships are more than your expenses, you must include the excess in income.

Example 2: If you have qualifying expenses of $3,000 and scholarships of $4,000, the amount of qualifying expenses is $0, and you have to include the additional $1,000 scholarship amount in income.

8

Some (not all!) scholarships can be included in income to increase your qualifying expenses. Pell grants can be treated that way.

Using example 1, if you have qualifying expenses of $3,000 and the $2,000 scholarship is a Pell grant you can include all of the scholarship in income and claim an AOTC on the full $3,000.

Using example 2, if you have qualifying expenses of $3,000 and the $4,000 scholarship is a Pell grant you have to include all $4,000 of the scholarship in income to claim the AOTC on the $3,000 expenses.

9

Scholarships are always the responsibility of the student. In order for the person claiming the dependency exemption (i.e. parent) to claim the maximum AOTC, the student may have to include scholarships in their income.

Using example 1 again, if the student includes the $2,000 in income, the parent can then claim the credit on all $3,000 in expenses. If the student is at the 10% tax bracket, it will cost $200, but the parent can reduce their tax by up to $2,250. If they don't owe tax to reduce they may still get $900.

10

Including scholarships in income doesn't always mean you have to pay tax on it. If your deductions and exemptions are more than your income, you won't have to pay income tax.

There are other articles on this site explaining education credits to tax professionals. Use the search box or browse in the Tax Accounting section to find them.

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