Deduction for Interest on Qualified Education Loans

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-116826-97]

RIN 1545-AW01

Deduction for Interest on Qualified Education Loans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and requests to videoconference

the public hearing.

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SUMMARY: This document contains proposed regulations relating to the

deduction for interest paid on qualified education loans. The proposed

regulations reflect changes to the law made by the Taxpayer Relief Act

of 1997, the Internal Revenue Service Restructuring and Reform Act of

1998, and the Omnibus Consolidated and Emergency Supplemental

Appropriations Act, 1999. The proposed regulations affect taxpayers who

pay interest on qualified education loans. This document also provides

notice that a public hearing will be held on the proposed regulations

and that persons outside the Washington, DC, area who wish to testify

at the hearing may request that the IRS videoconference the hearing to

their sites.

DATES: Written or electronically generated comments must be received by

April 21, 1999. Requests to videoconference the hearing to other sites

must be received by March 22, 1999.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-116826-97), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-

116826-97), Courier's Desk, Internal Revenue Service, 1111 Constitution

Avenue, NW., Washington, DC. Alternatively, taxpayers may submit

comments electronically via the Internet by selecting the ``Tax Regs''

option on the IRS Home Page, or by submitting comments directly to the

IRS Internet site at http://www.irs.ustreas.gov/prod/tax__regs/

comments. html. The IRS will publish the time and date of the public

hearing and the locations of any videoconferencing sites in an

announcement in the Federal Register.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, contact

John P. Moriarty, (202) 622-4950 (not a toll-free number); concerning

submissions of comments, the hearing, and/or to be placed on the

building access list to attend the hearing, contact Michael L.

Slaughter (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax

Regulations (26 CFR part 1). Section 202 of the Taxpayer Relief Act of

1997 (Pub. L. 105-34 (111 Stat. 778) (TRA 97)) added section 221 of the

Internal Revenue Code to allow a deduction from gross income for

certain interest paid on qualified education loans. On November 17,

1997, the IRS published Notice 97-60 (1997-46 I.R.B. 8) to provide

guidance on the higher education tax incentives enacted by TRA 97,

including the deduction for interest paid on qualified education loans.

Section 6004(b) of the Internal Revenue Service Restructuring and

Reform Act of 1998 (Pub. L. 105-206 (112 Stat. 685)) (RRA 98) and

section 4003(a) of the Omnibus Consolidated and Emergency Supplemental

Appropriations Act, 1999 (Pub. L. 105-277 (112 Stat. 2681)) (Omnibus

Act 99) made technical amendments to section 221. TRA 97 also added

section 6050S to the Internal Revenue Code, which requires the filing

of information returns by certain persons who receive payments of

interest that may be deductible as interest on a qualified education

loan. In 1998, the IRS published two notices describing the information

returns that are required under section 6050S for 1998 and 1999. On

January 20, 1998, the IRS published Notice 98-7 (1998-3 I.R.B. 54),

which describes the information reporting required under section 6050S

for 1998. On November 16, 1998, the IRS published Notice 98-54 (1998-46

I.R.B. 25), which modified Notice 98-7 to reflect a technical amendment

made by RRA 98 and extended the application of Notice 98-7, as so

modified, to information reporting required under section 6050S for

1999.

Explanation of Provisions

Section 221 allows taxpayers who are legally obligated to pay

interest on qualified education loans a federal income tax deduction

for their interest payments. The deduction is an adjustment to gross

income and, therefore, is available to eligible taxpayers regardless of

whether they itemize deductions.

The deduction is limited to $2,500 for taxable years beginning

after 2000. For taxable years 1998, 1999 and 2000, the limits are

$1,000, $1,500 and $2,000, respectively. Consistent with the income

limitations in section 221(b)(2), the proposed regulations provide that

the deduction is phased-out for taxpayers with modified adjusted gross

income between $40,000 and $55,000 ($60,000 and $75,000 for taxpayers

filing a joint return) for the taxable year. For taxable years

beginning after 2002, these amounts will be adjusted for inflation.

No deduction under section 221 is allowed in a taxable year to an

individual who is properly claimed as a dependent on another taxpayer's

federal income tax return for the taxable year. In addition, a taxpayer

who is married as of the end of a taxable year is allowed a deduction

under section 221 only if the taxpayer and the taxpayer's spouse file a

joint return for the taxable year.

Consistent with section 221(e)(1), the proposed regulations define

a qualified

[[Page 3258]]

education loan to mean any indebtedness incurred by the taxpayer solely

to pay qualified higher education expenses on behalf of a student

enrolled at least half-time in a program leading to a degree,

certificate, or other recognized educational credential. The student

must be the taxpayer, the taxpayer's spouse, or the taxpayer's

dependent at the time the indebtedness is incurred. In addition, the

qualified higher education expenses must be incurred within a

reasonable period of time before or after the indebtedness is incurred.

The requirement that the indebtedness be incurred solely to pay

qualified higher education expenses was added by RRA '98. Accordingly,

mixed use loans are not qualified education loans. Similarly, revolving

lines of credit (e.g., credit card debt) generally are not qualified

education loans, unless the borrower uses the line of credit solely to

pay qualified higher education expenses.

Consistent with section 221(e)(1), the proposed regulations provide

that a loan made by an individual who is related to the borrower,

within the meaning of section 267(b) or 707(b)(1), is not a qualified

education loan. For example, a loan from a parent or grandparent of the

borrower is not a qualified education loan. In addition, consistent

with a technical amendment to section 221(e) contained in the Omnibus

Act '99, the proposed regulations provide that loans made under any

qualified employer plan (within the meaning of section 72(p)(4)) or

made pursuant to any contract referred to in section 72(p)(5) are not

qualified education loans. The proposed regulations also provide that

loans that are not issued or guaranteed as part of a federal

postsecondary education loan program nonetheless may be qualified

education loans.

The proposed regulations provide that whether or not qualified

higher education expenses are paid within a reasonable period of time

before or after the indebtedness is incurred depends on all the facts

and circumstances. However, the proposed regulations provide two safe

harbors. The first safe harbor treats any education loan that is issued

as part of a federal postsecondary education loan program as meeting

the reasonable period requirement. The second safe harbor treats

qualified higher education expenses as paid or incurred within a

reasonable period of time before or after the indebtedness is incurred

if the expenses relate to a particular academic period and the proceeds

of the loan are disbursed within a period that begins 60 days prior to

the start of that academic period and ends 60 days after the end of

that academic period. The proposed regulations do not require actual

tracing of loan proceeds to the payment of qualified higher education

expenses.

The proposed regulations define an eligible educational institution

by reference to section 25A to mean any college, university, vocational

school, or other postsecondary educational institution that is

described in section 481 of the Higher Education Act of 1965 (20 U.S.C.

1088) as in effect on August 5, 1997, and certified by the U.S.

Department of Education to be eligible to participate in a student aid

program administered by that department. This category includes

generally all accredited public, nonprofit, and proprietary

postsecondary institutions. Consistent with section 221(e)(2), the

proposed regulations provide that, for purposes of the qualified

education loan interest deduction, eligible educational institutions

also include institutions that conduct an internship or residency

program leading to a degree or certificate awarded by an institution of

higher education, a hospital, or a health care facility that offers

postgraduate training.

Qualified higher education expenses are generally the same as the

cost of attendance as determined by the eligible educational

institution for purposes of calculating a student's financial need, in

accordance with section 472 of the Higher Education Act of 1965, 20

U.S.C. 1087ll, as in effect on August 4, 1997. Such expenses generally

include tuition, fees, room, board, books, equipment, and other

necessary expenses, such as transportation. However, for purposes of

calculating qualified higher education expenses, the amount of such

expenses must be reduced by educational assistance that the student

receives and excludes from gross income under section 117 (qualified

scholarships), section 127 (employer-provided educational assistance),

section 135 (redemption of U.S. savings bonds), and section 530

(distributions from education IRAs). In addition, such expenses must be

reduced by a veterans' or member of the armed forces' educational

assistance allowance under chapter 30, 31, 32, 34 or 35 of title 38

United States Code, or under chapter 1606 of title 10, United States

Code, and any other educational assistance that is excludable from the

student's gross income (other than as a gift, bequest, devise or

inheritance within the meaning of section 102(a)).

The qualified education loan interest deduction generally is

available only for interest payments made during the first 60 months in

which interest payments are required on the qualified education loan.

The proposed regulations provide that the 60-month period commences

with the month in which a loan first enters mandatory repayment status

and continues to elapse regardless of whether payments are actually

made, unless the repayment period is suspended for a period of

deferment or forbearance. The 60-month period may expire at different

times for different loans of the same borrower.

The date on which a qualified education loan enters repayment

status is determined by reference to the loan agreement or the federal

regulations governing the applicable federal postsecondary education

loan program.

The proposed regulations provide that a deduction is allowed for a

payment of interest that was required to be made in one month but that

actually is made in a subsequent month prior to the expiration of the

60-month period. A deduction is not allowed for a payment of interest

that was required to be made in one month but that actually is made in

a subsequent month after the expiration of the 60-month period.

The proposed regulations provide that a qualified education loan

and all refinancings of that loan are treated as a single loan for

purposes of calculating the 60-month period.

Consistent with section 221(d), as amended by RRA '98, the proposed

regulations provide special rules for calculating the 60-month period

for consolidated loans or collapsed loans. These rules generally mirror

the guidance contained in Notice 98-7 and provide that the 60-month

period begins on the most recent date on which any of the underlying

loans entered repayment status. See Conf. Rep. No. 599, 105th Cong., 2d

Sess., at 339 (1998).

If a qualified education loan entered repayment status prior to

January 1, 1998 (the effective date of section 221), the taxpayer is

not entitled to deduct any interest paid during that portion of the 60-

month period occurring prior to January 1, 1998. A deduction is allowed

only for interest due and paid during that portion, if any, of the 60-

month period remaining after December 31, 1997.

General tax principles apply in determining what is deductible

interest for purposes of section 221. However, to assist taxpayers, the

proposed regulations specifically provide that loan origination fees

and capitalized interest are interest and are deductible under section

221 as the stated principal amount of the qualified education loan is

repaid.

[[Page 3259]]

Proposed Effective Date

These regulations are proposed to be effective for interest paid

after the date they are published in the Federal Register as final

regulations. Taxpayers may rely on these proposed regulations for

guidance pending the issuance of final regulations. If, and to the

extent, future guidance is more restrictive than the guidance in these

proposed regulations, the future guidance will be applied without

retroactive effect.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) does not apply to these regulations, and, because the

regulations do not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Internal Revenue Code, this

notice of proposed rulemaking will be submitted to the Chief Counsel

for Advocacy of the Small Business Administration for comment on its

impact on small business.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any comments that are submitted timely

to the IRS. The IRS and Treasury Department request comments on the

clarity of the proposed rules and on how they can be made easier to

understand. All comments will be available for public inspection and

copying.

A public hearing will be scheduled in the Internal Revenue

Building, 1111 Constitution Avenue, NW., Washington, DC. The IRS

recognizes that persons outside the Washington, DC, area may also wish

to testify at the public hearing through videoconferencing. Requests to

include videoconferencing sites must be received by March 22, 1999. If

the IRS receives sufficient indications of interest to warrant

videoconferencing to a particular city, and if the IRS has

videoconferencing facilities available in that city on the date the

public hearing is to be scheduled, the IRS will try to accommodate the

requests.

The IRS will publish the time and date of the public hearing and

the locations of any videoconferencing sites in an announcement in the

Federal Register.

Drafting Information.

The principal author of these regulations is John P. Moriarty of

the Office of the Assistant Chief Counsel (Income Tax and Accounting).

However, other personnel from the IRS and Treasury Department

participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.221-1 also issued under 26 U.S.C. 221(d). * * *

Par. 2. Section 1.221-1 is added under the undesignated

centerheading ``Additional Itemized Deductions For Individuals'' to

read as follows:

Sec. 1.221-1 Deduction for interest on qualified education loans.

(a) In general. An individual taxpayer is allowed a deduction under

section 221 from gross income for certain interest paid during the

taxable year on a qualified education loan. The deduction is allowed

only with respect to interest paid on a qualified education loan during

the first 60 months that interest payments are required under the terms

of the loan. See paragraph (e) of this section for rules relating to

the 60-month rule.

(b) Eligibility--(1) Taxpayer must be legally obligated to make

interest payments. A taxpayer is allowed a deduction under section 221

only if the taxpayer is legally obligated to make interest payments

under the terms of the qualified education loan.

(2) Claimed dependents not eligible--(i) In general. An individual

is not allowed a deduction under section 221 for a taxable year if the

individual is a dependent (as defined in section 152) for whom a

deduction under section 151 is claimed on another taxpayer's federal

income tax return for the same taxable year (or, in the case of a

fiscal year taxpayer, the taxable year beginning in the same calendar

year as the individual's taxable year).

(ii) Examples. The following examples illustrate the rules of this

paragraph (b):

Example 1. Student not claimed as dependent. Student A pays $750

of interest on qualified education loans during 1998. Student A's

parents do not claim her as a dependent for 1998. Assuming all other

relevant requirements are met, Student A may deduct the $750 of

interest paid in 1998 under section 221.

Example 2. Student claimed as dependent. Student B pays $750 of

interest on qualified education loans during 1998. Only Student B is

legally obligated to make the payments. Student B's parent claims

him as a dependent and a deduction under section 151 is allowed with

respect to Student B in computing the parent's 1998 federal income

tax. Neither Student B nor Student B's parent may deduct the $750 of

interest paid in 1998 under section 221.

(3) Married taxpayers. If a taxpayer is married as of the close of

the taxable year, a deduction under this section is allowed only if the

taxpayer and the taxpayer's spouse file a joint return for that taxable

year.

(c) Maximum deduction. In any taxable year, the amount allowed as a

deduction under section 221 may not exceed the amount determined in

accordance with the following table:

------------------------------------------------------------------------

Maximum

Taxable year beginning in: deduction

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1998....................................................... $1,000

1999....................................................... 1,500

2000....................................................... 2,000

2001 and thereafter........................................ 2,500

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(d) Limitation based on modified adjusted gross income--(1) In

general. The deduction allowed under section 221 is phased out ratably

for taxpayers with modified adjusted gross income between $40,000 and

$55,000 ($60,000 and $75,000 for married individuals who file a joint

return). Taxpayers with modified adjusted gross income of $55,000 or

above (or $75,000 or above for joint filers) are not allowed a

deduction under section 221.

(2) Modified adjusted gross income defined. The term modified

adjusted gross income means the adjusted gross income (as defined in

section 62) of the taxpayer for the taxable year increased by any

amount excluded from gross income under section 911, 931, or 933

(relating to income earned abroad or from certain U.S. possessions or

Puerto Rico). Adjusted gross income must be determined under this

section after taking into account the exclusions, deductions and

limitations provided for by sections 86 (social security and tier 1

railroad retirement benefits), 135 (redemption of qualified U.S.

savings bonds), 137 (adoption assistance programs), 219 (deductible IRA

contributions) and 469 (limitation on passive activity losses and

credits).

(3) Inflation adjustment. For taxable years beginning after 2002,

the amounts in paragraph (d)(1) of this section will

[[Page 3260]]

be increased for inflation occurring after 2001 in accordance with

section 1(f)(3). If any amount adjusted under this paragraph (d)(3) is

not a multiple of $5,000, the amount will be rounded to the next lowest

multiple of $5,000.

(e) 60-month rule--(1) General rule. A deduction for interest paid

on a qualified education loan is allowed only for payments made during

the first 60 months that interest payments are required on the loan.

The 60-month period begins on the date the qualified education loan

first enters repayment status and ends 60 months later, unless the

period is suspended for periods of deferment or forbearance within the

meaning of paragraph (e)(3) of this section. The 60-month period

continues to elapse regardless of whether the required interest

payments are actually made. The date on which the qualified education

loan first enters repayment status is determined under the terms of the

loan agreement or, in the case of a loan issued or guaranteed under a

federal postsecondary education loan program, under applicable federal

regulations. For special rules relating to loan refinancings,

consolidated loans, and collapsed loans, see paragraph (h)(1) of this

section.

(2) Loans that entered repayment status prior to January 1, 1998.

In the case of any qualified education loan that entered repayment

status prior to January 1, 1998, no deduction is allowed under section

221 for interest paid during the portion of the 60-month period

described in paragraph (e)(1) of this section that occurred prior to

January 1, 1998. A deduction is allowed only for interest due and paid

during that portion, if any, of the 60-month period remaining after

December 31, 1997.

(3) Periods of deferment or forbearance. The 60-month period

described in paragraph (e)(1) of this section is suspended for any

period when interest payments are not required on a qualified education

loan because the borrower has been granted deferment or forbearance

(including postponement in anticipation of cancellation). However, in

the case of a qualified education loan that is not issued or guaranteed

under a federal postsecondary education loan program, the 60-month

period will be suspended under this paragraph (e)(3) only if the

borrower satisfies one of the conditions for deferment or forbearance

established by the U.S. Department of Education for federal student

loan programs under Title IV of the Higher Education Act of 1965, such

as half-time study at a postsecondary educational institution, study in

an approved graduate fellowship program or in an approved

rehabilitation program for the disabled, inability to find full-time

employment, economic hardship, or the performance of services in

certain occupations or federal programs. The 60-month period is not

suspended if, under the terms of the loan--

(i) Interest continues to accrue while the loan is in deferment or

forbearance; and

(ii) The taxpayer has the option of paying the interest currently

or requesting that the interest be capitalized, and the taxpayer elects

to make current interest payments.

(4) Late payments. A deduction is allowed for a payment of interest

that was required to be made in one month but that actually is made in

a subsequent month prior to the expiration of the 60-month period. A

deduction is not allowed for a payment of interest that was required to

be made in one month but that actually is made in a subsequent month

after the expiration of the 60-month period.

(5) Examples. The following examples illustrate the rules of this

paragraph (e). In the examples, assume that the institution is an

eligible educational institution, the loan is a qualified education

loan, and the student is legally obligated to make interest payments

under the terms of the loan:

Example 1. Payment prior to 60-month period. Student C obtains a

loan to attend College V. The terms of the loan provide that

interest accrues on the loan while C earns his undergraduate degree

but that C is not required to begin making payments of interest

until six full calendar months after he graduates. Nevertheless, C

voluntarily pays interest on the loan while attending College V. C

is not allowed a deduction for interest paid while attending College

V because the payments were made during a month prior to the start

of the 60-month period.

Example 2. Deferment option not exercised. The facts are the

same as Example 1, except that Student C makes no payments on the

loan while C is enrolled at College V. C graduates in June, 1999 and

is required to begin making monthly payments of principal and

interest on the loan in January, 2000. The 60-month period described

in paragraph (e)(1) of this section begins in January, 2000. In

August, 2000, C enrolls in graduate school on a full-time basis.

Under the terms of the loan, C may apply for deferment of the loan

payments while C is enrolled in graduate school. However, C elects

not to apply for deferment and continues to make monthly payments on

the loan during graduate school. Assuming all other relevant

requirements are met, C may deduct interest paid on the loan during

the 60-month period beginning in January, 2000, including interest

paid while C was enrolled in graduate school, but elected not to

defer payment.

Example 3. Late payment, within 60-month period. The facts are

the same as Example 2, except that, after the loan enters repayment

status in January, 2000, Student C makes no interest payments until

March, 2000. In March, 2000, C pays interest required to be paid for

the months of January, February, and March, 2000. Assuming all other

relevant requirements are met, C is allowed a deduction for the

interest paid in March for the months of January, February, and

March because the interest payments were required under the terms of

the loan and were paid within the 60-month period, even though the

January and February interest payments may be late.

Example 4. Late payment during deferment but within 60-month

period. The terms of Student D's qualified education loan require

her to begin making monthly payments of interest on the loan in

January, 2000. The 60-month period described in paragraph (e)(1) of

this section begins in January, 2000. D fails to make the required

interest payments for the months of November and December, 2000. In

January, 2001, D enrolls in graduate school on a half-time basis.

Under the terms of the loan, D is eligible for deferment of the loan

payments due while D is enrolled in graduate school. The deferment

is granted effective January 1, 2001. In March, 2001, while the loan

is in deferment, D pays the interest due for the months of November

and December, 2000. Assuming all other relevant requirements are

met, D is allowed a deduction for interest paid in March, 2001 for

the months of November and December, 2000 because the interest

payments were made paid prior to the expiration of the 60-month

period, even though the November and December interest payments were

late and were made while the loan was in deferment.

Example 5. 60-month period. The facts are the same as Example 4

except that Student D graduates from graduate school in December,

2004 and is required to begin making monthly payments of interest on

the loan in June, 2005. As of January, 2001, when the loan entered

deferment status, 12 months of the 60-month period had elapsed

(January-December, 2000). As of June, 2005, when the loan re-enters

repayment status, there are 48 months remaining in the 60-month

period for that loan.

Example 6. 60-month period. The terms of Student E's qualified

education loan require him to begin making monthly payments of

interest on the loan in November, 1999. The 60-month period

described in paragraph (e)(1) of this section begins in November,

1999. In January, 2000, E enrolls in graduate school on a half-time

basis. As permitted under the terms of the loan, E applies for

deferment of the loan payments due while E is enrolled in graduate

school. While awaiting formal notification from the lender that his

request for deferment has been granted, E pays interest due for the

month of January, 2000. In February, 2000, E receives notification

from the lender that deferment has been granted, effective as of

January 1, 2000. Assuming all other requirements are met, E is

allowed a deduction for interest paid in January, 2000, prior to his

receipt of the notification, even though the deferment

[[Page 3261]]

was granted retroactive to January 1, 2000. As of February, 2000,

there are 57 months remaining in the 60-month period for that loan.

Example 7. Reduction of 60-month period for months prior to

January 1, 1998. The first payment on a qualified education loan is

due on January 1, 1997. Thereafter, interest is required to be paid

on a monthly basis. The 60-month period for this loan begins on

January 1, 1997. However, no deduction is allowed for interest paid

by the borrower prior to January 1, 1998, the effective date of

section 221. Assuming all other relevant requirements are met, the

borrower may deduct interest due and paid on the loan during the 48

months beginning on January 1, 1998 (unless such period is extended

for periods of deferment or forbearance under paragraph (e)(3) of

this section).

(f) Definitions--(1) Eligible educational institution. In general,

an eligible educational institution means any college, university,

vocational school or other post-secondary educational institution that

is described in section 481 of the Higher Education Act of 1965 (20

U.S.C. 1088), as in effect on August 5, 1997, and is certified by the

U.S. Department of Education to be eligible to participate in student

aid programs administered by the Department, as described in section

25A(f)(2). In addition, for purposes of this section, an eligible

educational institution also includes an institution that conducts an

internship or residency program leading to a degree or certificate

awarded by an institution, a hospital, or a health care facility that

offers postgraduate training.

(2) Qualified higher education expenses--(i) In general. Qualified

higher education expenses means the cost of attendance (as defined in

section 472 of the Higher Education Act of 1965, 20 U.S.C. 1087ll, as

in effect on August 4, 1997), at an eligible educational institution,

reduced by the amounts described in paragraph (f)(2)(ii) of this

section. Consistent with section 472 of the Higher Education Act of

1965, 20 U.S.C. 1087ll, the cost of attendance is determined by the

eligible educational institution and includes tuition and fees normally

assessed a student carrying the same academic workload, an allowance

for room and board, and an allowance for books, supplies,

transportation and miscellaneous expenses of the student.

(ii) Reductions. Qualified higher education expenses must be

reduced by any amount paid to or on behalf of a student with respect to

such expenses that is--

(A) A qualified scholarship that is excludable from income under

section 117;

(B) A veterans' or member of the armed forces' educational

assistance allowance under chapter 30, 31, 32, 34 or 35 of title 38,

United States Code, or under chapter 1606 of title 10, United States

Code;

(C) Employer-provided educational assistance that is excludable

from income under section 127;

(D) Any other educational assistance that is excludable from gross

income (other than as a gift, bequest, devise, or inheritance within

the meaning of section 102(a));

(E) Any amount excluded from gross income under section 135

(relating to the redemption of United States savings bonds); or

(F) Any amount distributed from an education individual retirement

account described in section 530 and excluded from gross income.

(3) Qualified education loan--(i) In general. Qualified education

loan means indebtedness incurred by a taxpayer solely to pay qualified

higher education expenses that are--

(A) Incurred on behalf of a student who is the taxpayer, the

taxpayer's spouse, or a dependent (as defined in section 151) of the

taxpayer at the time the indebtedness is incurred;

(B) Paid or incurred within a reasonable period of time before or

after the indebtedness is incurred. Qualified higher education expenses

that are paid with the proceeds of education loans that are part of a

federal postsecondary education loan program are deemed to meet this

requirement. For other loans, except as provided in paragraph

(f)(3)(ii) of this section, what constitutes a reasonable period of

time is determined based on all the relevant facts and circumstances;

and

(C) Attributable to education provided during an academic period,

as described in section 25A and the regulations thereunder, when the

student is an eligible student as defined in section 25A(b)(3)

(requiring that the student be a degree candidate carrying at least

one-half the normal full-time workload).

(ii) Reasonable period safe harbor. For purposes of paragraph

(f)(3)(i)(B) of this section, qualified higher education expenses are

treated as paid or incurred within a reasonable period of time before

or after the indebtedness is incurred if the expenses relate to a

particular academic period and the loan proceeds are disbursed within a

period that begins 60 days prior to the start of that academic period

and ends 60 days after the end of that academic period.

(iii) Related party. A loan made by a person who is related to the

borrower, within the meaning of section 267(b) or 707(b)(1), is not a

qualified education loan. For example, a parent or grandparent of the

borrower is a related person. In addition, a loan made under any

qualified employer plan as defined in section 72(p)(4) or under any

contract referred to in section 72(p)(5) is not a qualified education

loan.

(iv) Not federally issued or guaranteed. A loan does not have to be

issued or guaranteed under a federal postsecondary education loan

program to be a qualified education loan.

(4) Examples. The following examples illustrate the rules in this

paragraph (f):

Example 1. Eligible educational institution. University Z is a

postsecondary educational institution described in section 481 of

the Higher Education Act of 1965. University Z has completed the

necessary paperwork and has been certified by the U.S. Department of

Education as eligible to participate in federal financial aid

programs administered by the Department, although University Z

chooses not to participate. University Z is an eligible educational

institution.

Example 2. Qualified education loan. Student F borrows money

from a commercial bank to pay qualified higher education expenses

related to his enrollment on a half-time basis in a graduate program

at an eligible educational institution. All the loan proceeds are

used to pay qualified higher education expenses incurred within a

reasonable period of time after the indebtedness is incurred. The

loan is not federally guaranteed. The commercial bank is not related

to Student F within the meaning of section 267(b) or 707(b)(1). The

fact that Student F's loan is not federally issued or guaranteed

does not prevent the loan from being a qualified education loan

within the meaning of section 221.

Example 3. Qualified higher education expenses. Student G

receives a $3,000 qualified scholarship for the 1999 Fall semester,

that is excludable from F's gross income under section 117. Student

G receives no other forms of financial assistance with respect to

the 1999 Fall semester. Student G's cost of attendance for the Fall

semester, as determined by Student G's eligible educational

institution for purposes of calculating a student's financial need

in accordance with section 472 of the Higher Education Act, is

$16,000. For the 1999 Fall semester, Student G has qualified higher

education expenses of $13,000 (the cost of attendance as determined

by the institution ($16,000) reduced by the qualified scholarship

proceeds excludable from gross income ($3,000)).

Example 4. Qualified education loan. Student H signs a

promissory note for a loan on August 15, 1999, to pay for qualified

higher education expenses for the 1999 Fall and 2000 Spring

semesters. On August 20, 1999, loan proceeds are disbursed by the

lender to Student H's college and credited to H's account to pay

qualified higher education expenses for the 1999 Fall semester, that

begins on August 23, 1999. On January 25, 2000, additional loan

proceeds are disbursed by the lender to Student H's college and

credited to H's account to pay qualified higher education expenses

for the 2000 Spring semester, that began on January 10,

[[Page 3262]]

2000. Student H's qualified higher education expenses for the two

semesters are paid within a reasonable period of time, as the first

loan disbursement was made within 60 days prior to the start of the

Fall 1999 semester and the second loan disbursement was made during

the Spring 2000 semester.

Example 5. Mixed-use loans. Student I signs a promissory note

for a loan which is secured by I's personal residence. Part of the

loan proceeds will be used to pay for certain improvements to I's

residence and part of the loan proceeds will be used to pay

qualified higher education expenses of I's spouse. Because the loan

is not incurred by I solely to pay qualified higher education

expenses, the loan is not a qualified education loan.

(g) Denial of double benefit. No deduction is allowed under this

section for any amount for which a deduction is allowed under another

provision of Chapter 1 of the Internal Revenue Code.

(h) Special rules--(1) 60-month limitation--(i) Refinancing. A

qualified education loan and all refinancings of that loan are treated

as a single loan for purposes of calculating the 60-month period

described in paragraph (e)(1) of this section.

(ii) Consolidated loans. A consolidated loan is a single loan that

refinances more than one qualified education loan of a borrower. For

consolidated loans, the 60-month period described in paragraph (e)(1)

of this section begins on the most recent date on which any of the

underlying loans entered repayment status and includes any subsequent

month in which the consolidated loan is in repayment status.

(iii) Collapsed loans. A collapsed loan is two or more qualified

education loans of a single borrower that are treated as a single

qualified education loan for loan servicing purposes and are not

separately accounted for by the lender or servicer. For a collapsed

loan, the 60-month period described in paragraph (e)(1) of this section

begins on the most recent date on which any of the underlying loans

entered repayment status and includes any subsequent month in which any

of the underlying loans is in repayment status.

(2) Loan origination fees and capitalized interest--(i) In general.

Loan origination fees (other than any fees for services) and

capitalized interest are interest and are deductible under this

section.

(ii) Capitalized interest defined. Capitalized interest means any

accrued and unpaid interest on a qualified education loan that is

capitalized by the lender (in accordance with the terms of the loan)

and added to the outstanding principal balance of the qualified

education loan.

(iii) Allocation of payments. Loan origination fees and capitalized

interest are deemed to be paid by the taxpayer when principal is repaid

on the qualified education loan. Accordingly, the taxpayer may deduct

the portion of a stated principal payment that is treated as the

payment of any loan origination fees or capitalized interest on the

loan. See Secs. 1.446-2(e) and 1.1275-2(a) for rules on how to allocate

payments between interest and principal. In general, under these rules,

a payment (regardless of its label) is treated first as a payment of

interest to the extent of the interest that has accrued and remains

unpaid as of the date the payment is due, second as a payment of any

loan origination fees or capitalized interest, until such amounts have

been reduced to zero, and third as a payment of principal.

(3) Examples. The following examples illustrate the rules of this

paragraph (h):

Example 1. Refinancing. Student J obtains a qualified education

loan to pay for an undergraduate degree at an eligible educational

institution. After graduation, Student J is required to make monthly

interest payments on the loan beginning in January 2000. Student J

makes the required interest payments for 15 months. In April 2001,

Student J borrows money from another lender to be used exclusively

to repay the first qualified education loan. The new loan requires

interest payments to start immediately. At the time Student J is

required to make interest payments on the new loan there are forty

five months remaining of the original 60-month period referred to in

paragraph (e)(1) of this section.

Example 2. Collapsed loans. To finance his education, Student K

obtains four separate qualified education loans from Lender B. The

loans enter repayment status on different dates. After all of

Student K's loans have entered repayment status, Lender B informs

Student K that all four loans will be transferred to Lender C.

Following the transfer, Lender C treats the loans as a single loan

for loan servicing purposes; Lender C sends Student K a single

statement that shows the total principal and interest, and does not

keep separate records with respect to each loan. The 60-month period

described in paragraph (e)(1) of this section begins on the most

recent date on which any of Student K's four loans entered repayment

status.

Example 3. Capitalized interest. Interest on Student L's

qualified education loan accrues while Student L is in school, but

Student L is not required to make any payments on the loan until six

months after he graduates. At that time, all accrued but unpaid

interest is capitalized by the lender and is added to the

outstanding principal amount of the loan. Thereafter, Student L is

required to make monthly payments of interest and principal on the

loan. For purposes of section 221, interest includes both stated

interest and capitalized interest. Therefore, in determining the

total amount of interest paid on the qualified education loan during

the 60-month period described in paragraph (e)(1) of this section,

Student L may deduct any principal payments that are treated as

payments of capitalized interest under paragraph (h)(4) of this

section.

(i) Effective date. This section applies to interest due and paid

after December 31, 1997, on a qualified education loan.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-986 Filed 1-20-99; 8:45 am]

BILLING CODE 4830-01-P