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education expenses as defined in Qualified education expenses in chapter 1. • The use of the money isn't restricted. Example 1. Joan paid $3,000 for tuition and $5,000 for room and board at University X. The university did not require her to pay any fees in addition to her tuition in or- der to enroll in or attend classes. To help pay these costs, she was awarded a $2,000 scholarship and a $4,000 stu- dent loan. The terms of the scholarship state that it can be used to pay any of Joan's college expenses. University X applies the $2,000 scholarship against Joan's $8,000 total bill, and Joan pays the $6,000 balance of her bill from University X with a combination of her stu- dent loan and her savings. Joan doesn't report any portion of the scholarship as income on her tax return. In figuring the amount of either education credit (Ameri- can opportunity or lifetime learning), Joan must reduce her qualified education expenses by the amount of the scholarship ($2,000) because she excluded the entire scholarship from her income. The student loan isn't tax-free educational assistance, so she doesn't need to reduce her qualified expenses by any part of the loan pro- ceeds. Joan is treated as having paid $1,000 in qualified education expenses ($3,000 tuition − $2,000 scholarship). Example 2. The facts are the same as in Example 1, except that Joan reports her entire scholarship as income on her tax return. Because Joan reported the entire $2,000 scholarship in her income, she doesn't need to re- duce her qualified education expenses. Joan is treated as having paid $3,000 in qualified education expenses. Coordination with Pell grants and other scholar- ships. You may be able to increase your American op- portunity credit when the student (you, your spouse, or your dependent) includes certain scholarships or fellow- ship grants in the student's gross income. Your credit may increase only if the amount of the student's qualified edu- cation expenses minus the total amount of scholarships and fellowship grants is less than $4,000. If this situation applies, consider including some or all of the scholarship or fellowship grant in the student's income in order to treat the included amount as paying nonqualified expenses in- stead of qualified education expenses. Nonqualified ex- penses are expenses such as room and board that aren't qualified education expenses such as tuition and related fees. Scholarships and fellowship grants that the student in- cludes in income don't reduce the student's qualified edu- cation expenses available to figure your American oppor- tunity credit. Thus, including enough scholarship or fellowship grant in the student's income to report up to $4,000 in qualified education expenses for your American opportunity credit may increase the credit by enough to in- crease your tax refund or reduce the amount of tax you owe even considering any increased tax liability from the additional income. However, the increase in tax liability as well as the loss of other tax credits may be greater than the additional American opportunity credit and may cause your tax refund to decrease or the amount of tax you owe to increase. Your specific circumstances will determine what amount, if any, of scholarship or fellowship grant to include in income to maximize your tax refund or minimize the amount of tax you owe. The scholarship or fellowship grant must be one that may qualify as a tax-free scholarship under the rules discussed in chapter 1. Also, the scholarship or fellowship grant must be one that may (by its terms) be used for nonqualified ex- penses. Finally, the amount of the scholarship or fellow- ship grant that is applied to nonqualified expenses can't exceed the amount of the student's actual nonqualified expenses that are paid in the tax year. This amount may differ from the student's living expenses estimated by the student's school in figuring the official cost of attendance under student aid rules. The fact that the educational institution applies the scholarship or fellowship grant to qualified education ex- penses, such as tuition and related fees, doesn't prevent the student from choosing to apply certain scholarships or fellowship grants to the student’s actual nonqualified ex- penses. By making this choice (that is, by including the part of the scholarship or fellowship grant applied to the student’s nonqualified expenses in income), the student may increase taxable income and may be required to file a tax return. But this allows payments made in cash, by check, by credit or debit card, or with borrowed funds such as a student loan to be applied to qualified education expenses. Example 1—No scholarship. Bill Pass, age 28 and unmarried, enrolled full-time in 2021 as a first-year student at a local college to earn a degree in law enforcement. This was his first year of postsecondary education. During 2021, he paid $5,600 for his qualified education expenses and $4,400 for his room and board for the fall 2021 se- mester. He and the college meet all the requirements for the American opportunity credit. Bill's adjusted gross in- come (AGI) and his MAGI, for purposes of figuring his credit, are $35,050. Bill claims the standard deduction of $12,550, resulting in taxable income of $22,500 and an in- come tax liability before credits of $2,504. Bill claims no credits other than the American opportunity credit. He fig- ures his American opportunity credit based on qualified education expenses of $4,000, which results in a credit of $2,500 and a tax liability after credits of $4 ($2,504 − $2,500). Example 2—Scholarship excluded from income. The facts are the same as in Example 1—No scholarship, except that Bill was awarded a $5,600 scholarship. Under the terms of his scholarship, it may be used to pay any ed- ucational expenses, including room and board. If Bill ex- cludes the scholarship from income, he will be deemed (for purposes of figuring his education credit) to have ap- plied the scholarship to pay his tuition, required fees, and course materials. His adjusted qualified education expen- ses would be zero and he wouldn't have an education credit. Therefore, Bill's tax liability after credits would be $2,504. Page 16 Chapter 2 American Opportunity Credit