For most college graduates, paying back student loans is part of growing-up. A portion of those payments is, of course, payment of interest. While most personal interest is not deductible for income tax purposes, the Internal Revenue Code (the “Tax Code” or “Code”) provides a special exception for student loan interest. The Code, in Section 221(a), provides:
Allowance of deduction. In the case of an individual, there shall be allowed as a deduction for the taxable year an amount equal to the interest paid by the taxpayer during the taxable year on any qualified education loan.
The Code limits this potential deduction in several ways, and this post discusses one such limitation. Many parents help pay for their children’s college by obtaining Parent PLUS Loans, which are government loans that recognize parents (and some others) are generally in a better credit-position to borrow than their children.
In addition to Parent PLUS Loans, students often take out loans in their own name to cover the remaining expenses. After graduating, students quite often pay back their loans and the Parent PLUS Loans as all of the debt went to pay for their education. As long as the student meets the Tax Code’s conditions, he or she can deduct the student loan interest paid on loans in their own name up to a certain amount. But can they deduct the interest they paid on the Parent PLUS Loans?
The answer is no – even when the student is the one actually making the loan payments from they own funds. The reason comes down to the Code’s definition of a “qualified education loan,” which reads as follows:
. . . any indebtedness incurred by the taxpayer solely to pay qualified higher education expenses . . . . 42 U.S.C. § 221(d)(1) (emphasis added).
With a Parent PLUS Loan, only parents are legally obligated to pay the loan and the loan’s interest. The student takes on no legal obligation, and therefore, no indebtedness where his or her parent utilizes a Parent PLUS Loan. IRS publications agree this is the case. Click the following link for the student loan interest portion of IRS Publication 970 with Joshua Werbeck’s notes.
Furthermore, students cannot simply execute an agreement with their parents obligating them to pay the interest. The Tax Code’s definition of qualified education loan exempts indebtedness to related persons and some business entities. See 42 U.S.C. § 221(d)(1) (“flush language” at the bottom of the subsection).
If you’d like, you can read the law yourself. Here is a link to Section 221(a) of the US Tax Code covering the student loan interest deduction with Joshua Werbeck’s notes.
But what happens to the potential deduction if the person actually paying the loan is not entitled to utilize the deduction. The person legally obligated to pay the qualified education loan, the parents in my example above, are entitled to the deduction even if they never actually made a loan payment.