[Federal Register Volume 69, Number 89 (Friday, May 7, 2004)]
[Rules and Regulations]
[Pages 25489-25499]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-10359]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9125]
RIN 1545-AW01


Deduction for Interest on Qualified Education Loans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
deduction under section 221 of the Internal Revenue Code (Code) for 
interest paid on qualified education loans. The final regulations 
reflect the enactment and amendment of section 221 by the Taxpayer 
Relief Act of 1997, the Internal Revenue Service Restructuring and 
Reform Act of 1998, the Omnibus Consolidated and Emergency Supplemental 
Appropriations Act of 1999, and the Economic Growth and Tax Relief 
Reconciliation Act of 2001. This document also contains amendments to 
the final regulations under section 6050S relating to the information 
reporting requirements for interest payments received on qualified 
education loans. The final regulations affect taxpayers who pay 
interest on qualified education loans and payees who receive payments 
of interest on qualified education loans.

DATES: Effective Date: These final regulations are effective May 7, 
2004.
    Applicability Dates: Section 1.221-1 is applicable to periods 
governed by section 221 as amended in 2001, which relates to interest 
paid on qualified education loans after December 31, 2001, and on or 
before December 31, 2010. Section 1.221-2 is applicable to interest due 
and paid on qualified education loans after January 21, 1999, but 
before January 1, 2002, and again after December 31, 2010. Taxpayers 
also may apply Sec.  1.221-2 to interest due and paid on qualified 
education loans after December 31, 1997, but before January 21, 1999. 
The amendments to Sec.  1.6050S-3 provide a transitional rule for 
certain interest payments with respect to qualified education loans 
made before September 1, 2004, and provide guidance applicable to 
qualified education loans made on or after that date.

FOR FURTHER INFORMATION CONTACT: Sean M. Dwyer at (202) 622-5020 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On January 21, 1999, the IRS published a notice of proposed 
rulemaking (REG-116826-97) in the Federal Register (64 FR 3257) under 
section 221 of the Code. The notice of proposed rulemaking implemented 
section 202 of the Taxpayer Relief Act of 1997, Public Law 105-34 (111 
Stat. 778), which added section 221 to the Code. The IRS received 
written, including electronic, comments responding to the proposed 
regulations. There were no requests for a public hearing and none was 
held.
    Subsequent to the publication of the proposed regulations, section 
412 of the Economic Growth and Tax Relief Reconciliation Act of 2001, 
Public Law 107-16 (115 Stat. 38) (2001 Act) amended section 221 by 
eliminating the 60-month limitation period and the restriction on 
deductions of interest a taxpayer pays during a period when the lender 
does not require payments. The 2001 Act also increased the income 
limitations relating to interest deductions under section 221 from 
$55,000 ($75,000 for married individuals filing jointly) to $65,000 
($130,000 for married individuals filing jointly) and the income phase-
out range from $40,000-$55,000 ($60,000-$75,000 for married individuals 
filing jointly) to $50,000-$65,000 ($100,000-$130,000 for married 
individuals filing jointly).
    The 2001 Act amendments apply to interest paid on qualified 
education loans after December 31, 2001. Accordingly, the final 
regulations appear in two sections to reflect the law before and after 
the effective date of the 2001 Act. Section 1.221-1 is applicable to 
periods governed by section 221 as amended in 2001, which relates to 
interest paid on qualified education loans after December 31, 2001, and 
on or before December 31, 2010. Section 1.221-2 is applicable to 
interest due and paid on qualified education loans after January 21, 
1999, but before January 1, 2002. Taxpayers also may apply Sec.  1.221-
2 to interest due and paid on qualified education loans after December 
31, 1997, but before January 21, 1999. Unless the 2001 Act amendments 
are extended by future legislation, section 1.221-2 also will apply to 
interest due and paid on qualified education loans after December 31, 
2010.
    After consideration of all the comments, the proposed regulations 
under section 221 are adopted as amended by this Treasury decision.
    On April 29, 2002, the IRS published final regulations (TD 8992) in 
the Federal Register (67 FR 20901) under

[[Page 25490]]

section 6050S relating to information reporting for interest payments 
received on qualified education loans. The Taxpayer Relief Act of 1997 
added section 6050S to the Code, as well as section 221.

Explanation and Summary of Comments

    Many of the comments concerned issues relating to the 60-month 
limitation period, which the 2001 Act eliminated. These comments are 
discussed in 7. and 8. below because the 60-month period continues to 
apply to interest on qualified education loans due and paid after 
December 31, 1997, but before January 1, 2002, and again after December 
31, 2010.

1. Treatment of Capitalized Interest and Certain Fees

    Several commentators discussed the treatment of capitalized 
interest, loan origination fees, late fees, and certain insurance fees. 
Courts have defined the term ``interest,'' for income tax purposes, as 
compensation paid for the use or forbearance of money. See, e.g., 
Deputy v. Du Pont, 308 U.S. 488 (1940). Consistent with this 
definition, the final regulations provide that capitalized interest is 
deductible as qualified education loan interest. Generally, fees, such 
as loan origination fees or late fees, are interest if the fees 
represent a charge for the use or forbearance of money. Therefore, if 
the fees represent compensation to the lender for the cost of specific 
services performed in connection with the borrower's account, the fees 
are not interest for Federal income tax purposes. See Rev. Rul. 69-188 
(1969-1 C.B. 54), amplified by Rev. Rul. 69-582 (1969-2 C.B. 29); see 
also, e.g., Trivett v. Commissioner, T.C. Memo. 1977-161, aff'd on 
other grounds, 611 F.2d 655 (6th Cir. 1979) (Tax Court found that 
certain fees, including insurance fees, were similar to payments for 
services rendered and not deductible as interest).
    Some commentators expressed confusion about how to apply the rules 
in the proposed regulations for allocating payments to principal or 
interest. In response to these comments, the final regulations provide 
guidance on the treatment and allocation of such amounts. Under the 
final regulations, a payment generally first applies to interest that 
has accrued and remains unpaid as of the date the payment is due and 
then applies to the outstanding principal. An example is included.

2. Interest Paid by Someone Other Than the Taxpayer

    Several commentators requested guidance on the treatment of an 
interest payment made by someone other than the taxpayer. To provide 
consistency with section 221(a), the final regulations provide, ``Under 
section 221, an individual taxpayer may deduct from gross income 
certain interest paid by the taxpayer during the taxable year on a 
qualified education loan.'' (Emphasis added.) The final regulations 
also clarify that certain third party payments of interest are treated 
as first paid to the taxpayer and then paid by the taxpayer to the 
lender, in a manner similar to the treatment of third party payments of 
tuition under Sec.  1.25A-5(b)(1). The final regulations provide for 
this treatment if a third party makes a payment of interest on a 
qualified education loan on behalf of a taxpayer.
    Thus, for example, if a third party pays interest on behalf of the 
taxpayer, as a gift to the taxpayer, the taxpayer may deduct this 
interest for Federal income tax purposes, assuming fulfillment of all 
other requirements of section 221. Similarly, if an employer pays 
interest to a lender on behalf of the taxpayer, and the taxpayer as 
required by section 61 includes the payment in income for Federal 
income tax purposes, the taxpayer may deduct this interest, assuming 
fulfillment of all other requirements of section 221.
    A commentator also recommended the allowance of a deduction to an 
individual even if the individual qualifies as a dependent of a 
taxpayer under section 151. This recommendation was not adopted because 
it is contrary to section 221(c).

3. Definition of Eligible Educational Institution

    Several commentators suggested expanding the definition of eligible 
educational institution in a manner that is not consistent with the 
statutory definition under sections 221(d)(2) (formerly section 
221(e)(2) (redesignated by the 2001 Act)) and 25A(f)(2). Accordingly, 
these comments were not adopted. Another commentator requested guidance 
on the deductibility of interest paid on a qualified education loan if 
the educational institution loses its status as an eligible educational 
institution after the end of the academic period for which the loan was 
incurred. The final regulations include a new example illustrating that 
the deductibility of interest on the loan is not affected by the 
institution's subsequent change in status.

4. Definition of Qualified Education Loan

    The definition of qualified education loan in section 221(d)(1) 
(formerly section 221(e)(1) (redesignated by the 2001 Act)) provides, 
in part, that the indebtedness must be incurred by the taxpayer solely 
to pay higher education expenses that are paid within a reasonable 
period of time before or after the indebtedness is incurred. Several 
comments were received in connection with this ``reasonable period of 
time'' requirement.
    One commentator suggested extending the 60-day safe harbor provided 
in the proposed regulations for satisfying the ``reasonable period of 
time'' requirement to 90 days or changing it so that the beginning of 
the safe harbor period is the earlier of 60 days prior to the start of 
the academic period or the end of the previous academic period. Two 
commentators suggested extending the safe harbor to 90 days after the 
end of the academic period. Another commentator expressed concern that 
expenses paid with loans disbursed outside the 60-day window would not 
satisfy the ``reasonable period of time'' requirement. Finally, one 
commentator interpreted the safe harbor to impose a 60-day limit on 
loans that are part of a federal postsecondary loan program.
    The final regulations provide that what constitutes a reasonable 
period of time is determined based on all the relevant facts and 
circumstances. The final regulations also provide that qualified higher 
education expenses are treated as paid or incurred within a reasonable 
period of time under the following circumstances: (1) The expenses are 
paid with the proceeds of education loans that are part of a federal 
postsecondary education loan program; or (2) the expenses relate to a 
particular academic period and the loan proceeds used to pay the 
expenses are disbursed within a period that begins 90 days before the 
start of, and ends 90 days after the end of, the academic period to 
which the expenses relate.
    One commentator recommended expansion of the federal loan safe 
harbor described above to include expenses paid with the proceeds of 
any non-federal loan disbursed under policies mirroring the awarding 
and disbursement policies governing certain federal loans. Although the 
final regulations do not adopt this suggestion, the IRS and Treasury 
Department believe that loans described by the commentator probably 
would fall within the 90-day safe harbor, or satisfy the ``reasonable 
period of time''

[[Page 25491]]

requirement based on the facts and circumstances.
    Another requirement of a ``qualified education loan'' is that the 
borrower obtain the loan ``solely'' to pay higher education expenses. 
One commentator suggested that if a taxpayer refinances a qualified 
education loan and receives an amount in excess of the original 
qualified education loan, the taxpayer may take an interest deduction 
under section 221 for interest paid on the refinanced loan. The 
commentator is correct, but only if the taxpayer uses the excess amount 
solely to pay higher education expenses and satisfies all other 
requirements of a qualified education loan. Thus, if the taxpayer uses 
the excess amount for any other purpose, the refinanced loan is not 
``solely'' to pay higher education expenses, and no interest paid on 
the loan will be deductible.

5. Miscellaneous Comments and Changes

    Federal Postsecondary Education Loan Program--The final regulations 
clarify that a federal postsecondary education loan program includes, 
but is not limited to, the Federal Perkins Loan, Federal Family 
Education Loan, and William D. Ford Federal Direct Loan Programs under 
Title IV of the Higher Education Act of 1965, and the Health Education 
Assistance Loan and the Nursing Student Loan Programs under Titles VII 
and VIII of the Public Health Service Act.
    Eligible Educational Institution--Although the Higher Education 
Amendments Act of 1998 moved section 481 from Title IV to Title I, the 
regulations do not reflect this change, as the statutory language 
refers to section 481 of the Higher Education Act as in effect on the 
date that section 221 was enacted.
    Interest Charges on a University In-House Deferred Payment Plan--
One commentator requested clarification of the deductibility of 
interest charges on a university's in-house deferred payment plan, 
which is a revolving credit account that can include a variety of 
expenditures in addition to qualified higher education expenses. This 
situation is addressed by Example 6 of Sec.  1.221-1(e)(4) and Example 
6 of Sec.  1.221-2(f)(4) concerning mixed use loans.

6. Refinanced and Consolidated Loans

    The final regulations reserve a place for more detailed treatment 
of refinanced and consolidated loans.

7. Periods of Deferment or Forbearance

    Prior to the 2001 Act, section 221(d) stated that a ``deduction 
shall be allowed under this section only with respect to interest paid 
on any qualified education loan during the first 60 months (whether or 
not consecutive) in which interest payments are required.''
    Some commentators recommended that the 60-month limitation period 
should not be suspended during a period of deferment or forbearance. 
Other commentators suggested that the 60-month limitation period should 
be suspended during all periods of deferment or forbearance, whether or 
not the taxpayer makes payments. Commentators also asked whether rules 
under which the 60-month period is not suspended apply to loans made 
under federal programs as well as non-federal loans. Finally, 
commentators asked whether interest payments made during periods of 
reduced payment forbearance are deductible.
    Section 221, prior to the 2001 Act, and the legislative history 
provide that only interest payments required under the terms of a loan 
are deductible. Under that provision, interest a borrower pays 
voluntarily during a period when payments are not required, such as 
during a period of deferment or forbearance or before loan repayment 
begins, is not deductible.
    Therefore, Sec.  1.221-2 of the final regulations retains the rule 
that interest payments are not deductible if paid voluntarily during a 
period of deferment or forbearance. However, the final regulations 
provide that interest payments made during a period of deferment, 
forbearance, or reduced payment forbearance are deductible if required 
as part of the terms of the deferment, forbearance, or reduced payment 
agreement. The final regulations include a new example involving 
reduced payment forbearance.
    In addition, Sec.  1.221-2 of the final regulations provides for 
suspension of the 60-month period for loans not issued or guaranteed 
under a federal postsecondary education loan program under certain 
conditions. The promissory note must contain conditions for deferment 
or forbearance that are substantially similar to the conditions 
established by the U.S. Department of Education for Federal student 
loan programs under Title IV of the Higher Education Act of 1965 and 
the borrower must satisfy one of those conditions.

8. Start of the 60-Month Limitation Period

    A commentator expressed concern that the month a loan first enters 
repayment status may not be the same as the month the first interest 
payment is required. Section 1.221-2 of the final regulations clarifies 
that the beginning of the 60-month period commences on the first day of 
the month in which the first interest payment is required.

9. Information Reporting for Interest Payments Received on Qualified 
Education Loans

    Section 6050S requires information reporting by certain lenders or 
other payees that receive payments of interest on qualified education 
loans. Section 1.6050S-3(b)(1) provides that interest includes stated 
interest, loan origination fees (other than fees for services), and 
capitalized interest. Section 1.6050S-3(e)(1) provides a special 
transitional rule for reporting loan origination fees and capitalized 
interest. Under the transitional rule, a payee is not required to 
report payments of loan origination fees and capitalized interest for 
loans made before January 1, 2004.
    Several commentators representing payees requested that the 
transitional rule be extended because the necessary programming changes 
to capture and report these amounts could not be made in the absence of 
final regulations under section 221. Based on the comments received, 
these regulations amend Sec.  1.6050S-3(e)(1) to extend the 
transitional rule to loans made before September 1, 2004.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 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 Code, the proposed 
regulations that preceded these regulations were submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Drafting Information

    The principal author of these final regulations is Sean M. Dwyer, 
Office of the Associate Chief Counsel (Income Tax & Accounting). 
However, other personnel from the IRS and Treasury Department 
participated in their development.

[[Page 25492]]

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
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 1.221-2 also issued under 26 U.S.C. 221(d). * * *
    Section 1.6050S-3 also issued under 26 U.S.C. 6050S(g). * * *


0
2. Sections 1.221-1 and 1.221-2 are added to read as follows:


Sec.  1.221-1  Deduction for interest paid on qualified education loans 
after December 31, 2001.

    (a) In general--(1) Applicability. Under section 221, an individual 
taxpayer may deduct from gross income certain interest paid by the 
taxpayer during the taxable year on a qualified education loan. See 
paragraph (b)(4) of this section for rules on payments of interest by 
third parties. The rules of this section are applicable to periods 
governed by section 221 as amended in 2001, which relates to deductions 
for interest paid on qualified education loans after December 31, 2001, 
in taxable years ending after December 31, 2001, and on or before 
December 31, 2010. For rules applicable to interest due and paid on 
qualified education loans after January 21, 1999, if paid before 
January 1, 2002, see Sec.  1.221-2. Taxpayers also may apply Sec.  
1.221-2 to interest due and paid on qualified education loans after 
December 31, 1997, but before January 21, 1999. To the extent that the 
effective date limitation (sunset) of the 2001 amendment remains in 
force unchanged, section 221 before amendment in 2001, to which Sec.  
1.221-2 relates, also applies to interest due and paid on qualified 
education loans in taxable years beginning after December 31, 2010.
    (2) Example. The following example illustrates the rules of this 
paragraph (a). In the example, assume that the institution the student 
attends is an eligible educational institution, the loan is a qualified 
education loan, the student is legally obligated to make interest 
payments under the terms of the loan, and any other applicable 
requirements, if not otherwise specified, are fulfilled. The example is 
as follows:

    Example. Effective dates. Student A begins to make monthly 
interest payments on her loan beginning January 1, 1997. Student A 
continues to make interest payments in a timely fashion. However, 
under the effective date provisions of section 221, no deduction is 
allowed for interest Student A pays prior to January 1, 1998. 
Student A may deduct interest due and paid on the loan after 
December 31, 1997. Student A may apply the rules of Sec.  1.221-2 to 
interest due and paid during the period beginning January 1, 1998, 
and ending January 20, 1999. Interest due and paid during the period 
January 21, 1999, and ending December 31, 2001, is deductible under 
the rules of Sec.  1.221-2, and interest paid after December 31, 
2001, is deductible under the rules of this section.

    (b) Eligibility--(1) Taxpayer must have a legal obligation to make 
interest payments. A taxpayer is entitled to a deduction under section 
221 only if the taxpayer has a legal obligation to make interest 
payments under the terms of the qualified education loan.
    (2) Claimed dependents not eligible--(i) In general. An individual 
is not entitled to a deduction under section 221 for a taxable year if 
the individual is a dependent (as defined in section 152) for whom 
another taxpayer is allowed a deduction under section 151 on a 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)(2):

    Example 1. Student not claimed as dependent.  Student B pays 
$750 of interest on qualified education loans during 2003. Student 
B's parents are not allowed a deduction for her as a dependent for 
2003. Assuming fulfillment of all other relevant requirements, 
Student B may deduct under section 221 the $750 of interest paid in 
2003.
    Example 2. Student claimed as dependent.  Student C pays $750 of 
interest on qualified education loans during 2003. Only Student C 
has the legal obligation to make the payments. Student C's parent 
claims him as a dependent and is allowed a deduction under section 
151 with respect to Student C in computing the parent's 2003 Federal 
income tax. Student C is not entitled to a deduction under section 
221 for the $750 of interest paid in 2003. Because Student C's 
parent was not legally obligated to make the payments, Student C's 
parent also is not entitled to a deduction for the interest.

    (3) Married taxpayers. If a taxpayer is married as of the close of 
a taxable year, he or she is entitled to a deduction under this section 
only if the taxpayer and the taxpayer's spouse file a joint return for 
that taxable year.
    (4) Payments of interest by a third party--(i) In general. If a 
third party who is not legally obligated to make a payment of interest 
on a qualified education loan makes a payment of interest on behalf of 
a taxpayer who is legally obligated to make the payment, then the 
taxpayer is treated as receiving the payment from the third party and, 
in turn, paying the interest.
    (ii) Examples. The following examples illustrate the rules of this 
paragraph (b)(4):

    Example 1. Payment by employer.  Student D obtains a qualified 
education loan to attend college. Upon Student D's graduation from 
college, Student D works as an intern for a non-profit organization 
during which time Student D's loan is in deferment and Student D 
makes no interest payments. As part of the internship program, the 
non-profit organization makes an interest payment on behalf of 
Student D after the deferment period. This payment is not excluded 
from Student D's income under section 108(f) and is treated as 
additional compensation includible in Student D's gross income. 
Assuming fulfillment of all other requirements of section 221, 
Student D may deduct this payment of interest for Federal income tax 
purposes.
    Example 2. Payment by parent.  Student E obtains a qualified 
education loan to attend college. Upon graduation from college, 
Student E makes legally required monthly payments of principal and 
interest. Student E's mother makes a required monthly payment of 
interest as a gift to Student E. A deduction for Student E as a 
dependent is not allowed on another taxpayer's tax return for that 
taxable year. Assuming fulfillment of all other requirements of 
section 221, Student E may deduct this payment of interest for 
Federal income tax purposes.

    (c) Maximum deduction. The amount allowed as a deduction under 
section 221 for any taxable year may not exceed $2,500.
    (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 $50,000 and 
$65,000 ($100,000 and $130,000 for married individuals who file a joint 
return). Section 221 does not allow a deduction for taxpayers with 
modified adjusted gross income of $65,000 or above ($130,000 or above 
for married individuals who file a joint return). See paragraph (d)(3) 
of this section for inflation adjustment of amounts in this paragraph 
(d)(1).
    (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 United States 
possessions or Puerto Rico). Modified adjusted gross income must be 
determined under this

[[Page 25493]]

section after taking into account the inclusions, exclusions, 
deductions, and limitations provided by sections 86 (social security 
and tier 1 railroad retirement benefits), 135 (redemption of qualified 
United States savings bonds), 137 (adoption assistance programs), 219 
(deductible qualified retirement contributions), and 469 (limitation on 
passive activity losses and credits), but before taking into account 
the deductions provided by sections 221 and 222 (qualified tuition and 
related expenses).
    (3) Inflation adjustment. For taxable years beginning after 2002, 
the amounts in paragraph (d)(1) of this section will be increased for 
inflation occurring after 2001 in accordance with section 221(f)(1). If 
any amount adjusted under section 221(f)(1) is not a multiple of 
$5,000, the amount will be rounded to the next lowest multiple of 
$5,000.
    (e) Definitions--(1) Eligible educational institution. In general, 
an eligible educational institution means any college, university, 
vocational school, or other postsecondary educational institution 
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 as eligible to participate in student aid 
programs administered by the Department, as described in section 
25A(f)(2) and Sec.  1.25A-2(b). 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 (e)(2)(ii) of this 
section. Consistent with section 472 of the Higher Education Act of 
1965, a student's cost of attendance is determined by the eligible 
educational institution and includes tuition and fees normally assessed 
a student carrying the same academic workload as the student, 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 are reduced by 
any amount that is paid to or on behalf of a student with respect to 
such expenses and that is--
    (A) A qualified scholarship that is excludable from income under 
section 117;
    (B) An educational assistance allowance for a veteran or member of 
the armed forces 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 amount that is described in section 25A(g)(2)(C) 
(relating to amounts excludable from gross income as educational 
assistance);
    (E) Any otherwise includible amount excluded from gross income 
under section 135 (relating to the redemption of United States savings 
bonds);
    (F) Any otherwise includible amount distributed from a Coverdell 
education savings account and excluded from gross income under section 
530(d)(2); or
    (G) Any otherwise includible amount distributed from a qualified 
tuition program and excluded from gross income under section 
529(c)(3)(B).
    (3) Qualified education loan--(i) In general. A 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 152) of the 
taxpayer at the time the taxpayer incurs the indebtedness;
    (B) 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 
half the normal full-time workload); and
    (C) Paid or incurred within a reasonable period of time before or 
after the taxpayer incurs the indebtedness.
    (ii) Reasonable period. Except as otherwise provided in this 
paragraph (e)(3)(ii), what constitutes a reasonable period of time for 
purposes of paragraph (e)(3)(i)(C) of this section generally is 
determined based on all the relevant facts and circumstances. However, 
qualified higher education expenses are treated as paid or incurred 
within a reasonable period of time before or after the taxpayer incurs 
the indebtedness if--
    (A) The expenses are paid with the proceeds of education loans that 
are part of a Federal postsecondary education loan program; or
    (B) The expenses relate to a particular academic period and the 
loan proceeds used to pay the expenses are disbursed within a period 
that begins 90 days prior to the start of that academic period and ends 
90 days after the end of that academic period.
    (iii) Related party. A qualified education loan does not include 
any indebtedness owed to a person who is related to the taxpayer, 
within the meaning of section 267(b) or 707(b)(1). For example, a 
parent or grandparent of the taxpayer is a related person. In addition, 
a qualified education loan does not include 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).
    (iv) Federal issuance or guarantee not required. A loan does not 
have to be issued or guaranteed under a Federal postsecondary education 
loan program to be a qualified education loan.
    (v) Refinanced and consolidated indebtedness--(A) In general. A 
qualified education loan includes indebtedness incurred solely to 
refinance a qualified education loan. A qualified education loan 
includes a single, consolidated indebtedness incurred solely to 
refinance two or more qualified education loans of a borrower.
    (B) Treatment of refinanced and consolidated indebtedness. 
[Reserved.]
    (4) Examples. The following examples illustrate the rules of this 
paragraph (e):

    Example 1. Eligible educational institution.  University F is a 
postsecondary educational institution described in section 481 of 
the Higher Education Act of 1965. The U.S. Department of Education 
has certified that University F is eligible to participate in 
federal financial aid programs administered by that Department, 
although University F chooses not to participate. University F is an 
eligible educational institution.
    Example 2. Qualified higher education expenses.  Student G 
receives a $3,000 qualified scholarship for the 2003 fall semester 
that is excludable from Student G's gross income under section 117. 
Student G receives no other forms of financial assistance with 
respect to the 2003 fall semester. Student G's cost of attendance 
for the 2003 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 2003 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 3. Qualified education loan.  Student H 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. Student H uses all the loan 
proceeds to pay qualified higher education expenses incurred within 
a reasonable period of time after incurring the indebtedness. The 
loan is not federally

[[Page 25494]]

guaranteed. The commercial bank is not related to Student H within 
the meaning of section 267(b) or 707(b)(1). Student H's loan is a 
qualified education loan within the meaning of section 221.
    Example 4. Qualified education loan.  Student I signs a 
promissory note for a loan on August 15, 2003, to pay for qualified 
higher education expenses for the 2003 fall and 2004 spring 
semesters. On August 20, 2003, the lender disburses loan proceeds to 
Student I's college. The college credits them to Student I's account 
to pay qualified higher education expenses for the 2003 fall 
semester, which begins on August 25, 2003. On January 26, 2004, the 
lender disburses additional loan proceeds to Student I's college. 
The college credits them to Student I's account to pay qualified 
higher education expenses for the 2004 spring semester, which began 
on January 12, 2004. Student I's qualified higher education expenses 
for the two semesters are paid within a reasonable period of time, 
as the first loan disbursement occurred within the 90 days prior to 
the start of the fall 2003 semester and the second loan disbursement 
occurred during the spring 2004 semester.
    Example 5. Qualified education loan.  The facts are the same as 
in Example 4 except that in 2005 the college is not an eligible 
educational institution because it loses its eligibility to 
participate in certain federal financial aid programs administered 
by the U.S. Department of Education. The qualification of Student 
I's loan, which was used to pay for qualified higher education 
expenses for the 2003 fall and 2004 spring semesters, as a qualified 
education loan is not affected by the college's subsequent loss of 
eligibility.
    Example 6. Mixed-use loans.  Student J signs a promissory note 
for a loan secured by Student J's personal residence. Student J will 
use part of the loan proceeds to pay for certain improvements to 
Student J's residence and part of the loan proceeds to pay qualified 
higher education expenses of Student J's spouse. Because Student J 
obtains the loan not solely to pay qualified higher education 
expenses, the loan is not a qualified education loan.

    (f) Interest--(1) In general. Amounts paid on a qualified education 
loan are deductible under section 221 if the amounts are interest for 
Federal income tax purposes. For example, interest includes--
    (i) Qualified stated interest (as defined in Sec.  1.1273-1(c)); 
and
    (ii) Original issue discount, which generally includes capitalized 
interest. For purposes of section 221, capitalized interest means any 
accrued and unpaid interest on a qualified education loan that, in 
accordance with the terms of the loan, is added by the lender to the 
outstanding principal balance of the loan.
    (2) Operative rules for original issue discount--(i) In general. 
The rules to determine the amount of original issue discount on a loan 
and the accruals of the discount are in sections 163(e), 1271 through 
1275, and the regulations thereunder. In general, original issue 
discount is the excess of a loan's stated redemption price at maturity 
(all payments due under the loan other than qualified stated interest 
payments) over its issue price (the amount loaned). Although original 
issue discount generally is deductible as it accrues under section 
163(e) and Sec.  1.163-7, original issue discount on a qualified 
education loan is not deductible until paid. See paragraph (f)(3) of 
this section to determine when original issue discount is paid.
    (ii) Treatment of loan origination fees by the borrower. If a loan 
origination fee is paid by the borrower other than for property or 
services provided by the lender, the fee reduces the issue price of the 
loan, which creates original issue discount (or additional original 
issue discount) on the loan in an amount equal to the fee. See Sec.  
1.1273-2(g). For an example of how a loan origination fee is taken into 
account, see Example 2 of paragraph (f)(4) of this section.
    (3) Allocation of payments. See Sec. Sec.  1.446-2(e) and 1.1275-
2(a) for rules on allocating payments between interest and principal. 
In general, these rules treat a payment 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, and second as a payment of principal. The 
characterization of a payment as either interest or principal under 
these rules applies regardless of how the parties label the payment 
(either as interest or principal). Accordingly, the taxpayer may deduct 
the portion of a payment labeled as principal that these rules treat as 
a payment of interest on the loan, including any portion attributable 
to capitalized interest or loan origination fees.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (f). In the examples, assume that the institution the student 
attends is an eligible educational institution, the loan is a qualified 
education loan, the student is legally obligated to make interest 
payments under the terms of the loan, and any other applicable 
requirements, if not otherwise specified, are fulfilled. The examples 
are as follows:
    Example 1. Capitalized interest.  Interest on Student K's loan 
accrues while Student K is in school, but Student K is not required 
to make any payments on the loan until six months after he graduates 
or otherwise leaves school. At that time, the lender capitalizes all 
accrued but unpaid interest and adds it to the outstanding principal 
amount of the loan. Thereafter, Student K is required to make 
monthly payments of interest and principal on the loan. The interest 
payable on the loan, including the capitalized interest, is original 
issue discount. See section 1273 and the regulations thereunder. 
Therefore, in determining the total amount of interest paid on the 
loan each taxable year, Student K may deduct any payments that Sec.  
1.1275-2(a) treats as payments of interest, including any principal 
payments that are treated as payments of capitalized interest. See 
paragraph (f)(3) of this section.
    Example 2. Allocation of payments.  The facts are the same as in 
Example 1, except that, in addition, the lender charges Student K a 
loan origination fee, which is not for any property or services 
provided by the lender. Under Sec.  1.1273-2(g), the loan 
origination fee reduces the issue price of the loan, which reduction 
increases the amount of original issue discount on the loan by the 
amount of the fee. The amount of original issue discount (which 
includes the capitalized interest and loan origination fee) that 
accrues each year is determined under section 1272 and Sec.  1.1272-
1. In effect, the loan origination fee accrues over the entire term 
of the loan. Because the loan has original issue discount, the 
payment ordering rules in Sec.  1.1275-2(a) must be used to 
determine how much of each payment is interest for federal tax 
purposes. See paragraph (f)(3) of this section. Under Sec.  1.1275-
2(a), each payment (regardless of its designation by the parties as 
either interest or principal) generally is treated first as a 
payment of original issue discount, to the extent of the original 
issue discount that has accrued as of the date the payment is due 
and has not been allocated to prior payments, and second as a 
payment of principal. Therefore, in determining the total amount of 
interest paid on the qualified education loan for a taxable year, 
Student K may deduct any payments that the parties label as 
principal but that are treated as payments of original issue 
discount under Sec.  1.1275-2(a).

    (g) Additional Rules--(1) Payment of interest made during period 
when interest payment not required. Payments of interest on a qualified 
education loan to which this section is applicable are deductible even 
if the payments are made during a period when interest payments are not 
required because, for example, the loan has not yet entered repayment 
status or is in a period of deferment or forbearance.
    (2) Denial of double benefit. No deduction is allowed under this 
section for any amount for which a deduction is allowable under another 
provision of Chapter 1 of the Internal Revenue Code. No deduction is 
allowed under this section for any amount for which an exclusion is 
allowable under section 108(f) (relating to cancellation of 
indebtedness).
    (3) Examples. The following examples illustrate the rules of this 
paragraph (g). In the examples, assume that the institution the student 
attends is an eligible educational institution, the loan is a qualified 
education loan, and the student is legally obligated to make

[[Page 25495]]

interest payments under the terms of the loan:

    Example 1. Voluntary payment of interest before loan has entered 
repayment status. Student L obtains a loan to attend college. The 
terms of the loan provide that interest accrues on the loan while 
Student L earns his undergraduate degree but that Student L is not 
required to begin making payments of interest until six full 
calendar months after he graduates or otherwise leaves school. 
Nevertheless, Student L voluntarily pays interest on the loan during 
2003, while enrolled in college. Assuming all other relevant 
requirements are met, Student L is allowed a deduction for interest 
paid while attending college even though the payments were made 
before interest payments were required.
    Example 2. Voluntary payment during period of deferment or 
forbearance.  The facts are the same as in Example 2, except that 
Student L makes no payments on the loan while enrolled in college. 
Student L graduates in June 2003 and begins making monthly payments 
of principal and interest on the loan in January 2004, as required 
by the terms of the loan. In August 2004, Student L enrolls in 
graduate school on a full-time basis. Under the terms of the loan, 
Student L may apply for deferment of the loan payments while Student 
L is enrolled in graduate school. Student L applies for and receives 
a deferment on the outstanding loan. However, Student L continues to 
make some monthly payments of interest during graduate school. 
Student L may deduct interest paid on the loan during the period 
beginning in January 2004, including interest paid while Student L 
is enrolled in graduate school.

    (h) Effective date. This section is applicable to periods governed 
by section 221 as amended in 2001, which relates to interest paid on a 
qualified education loan after December 31, 2001, in taxable years 
ending after December 31, 2001, and on or before December 31, 2010.


Sec.  1.221-2  Deduction for interest due and paid on qualified 
education loans before January 1, 2002.

    (a) In general. Under section 221, an individual taxpayer may 
deduct from gross income certain interest due and paid by the taxpayer 
during the taxable year on a qualified education loan. The deduction is 
allowed only with respect to interest due and 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. See paragraph (b)(4) of this 
section for rules on payments of interest by third parties. The rules 
of this section are applicable to interest due and paid on qualified 
education loans after January 21, 1999, if paid before January 1, 2002. 
Taxpayers also may apply the rules of this section to interest due and 
paid on qualified education loans after December 31, 1997, but before 
January 21, 1999. To the extent that the effective date limitation 
(``sunset'') of the 2001 amendment remains in force unchanged, section 
221 before amendment in 2001, to which this section relates, also 
applies to interest due and paid on qualified education loans in 
taxable years beginning after December 31, 2010. For rules applicable 
to periods governed by section 221 as amended in 2001, which relates to 
deductions for interest paid on qualified education loans after 
December 31, 2001, in taxable years ending after December 31, 2001, and 
before January 1, 2011, see Sec.  1.221-1.
    (b) Eligibility--(1) Taxpayer must have a legal obligation to make 
interest payments. A taxpayer is entitled to a deduction under section 
221 only if the taxpayer has a legal obligation to make interest 
payments under the terms of the qualified education loan.
    (2) Claimed dependents not eligible--(i) In general. An individual 
is not entitled to a deduction under section 221 for a taxable year if 
the individual is a dependent (as defined in section 152) for whom 
another taxpayer is allowed a deduction under section 151 on a 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)(2):

    Example 1. Student not claimed as dependent.  Student A pays 
$750 of interest on qualified education loans during 1998. Student 
A's parents are not allowed a deduction for her as a dependent for 
1998. Assuming fulfillment of all other relevant requirements, 
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 
has the legal obligation to make the payments. Student B's parent 
claims him as a dependent and is allowed a deduction under section 
151 with respect to Student B in computing the parent's 1998 Federal 
income tax. Student B may not deduct the $750 of interest paid in 
1998 under section 221. Because Student B's parent was not legally 
obligated to make the payments, Student B's parent also may not 
deduct the interest.

    (3) Married taxpayers. If a taxpayer is married as of the close of 
a taxable year, he or she is entitled to a deduction under this section 
only if the taxpayer and the taxpayer's spouse file a joint return for 
that taxable year.
    (4) Payments of interest by a third party--(i) In general. If a 
third party who is not legally obligated to make a payment of interest 
on a qualified education loan makes a payment of interest on behalf of 
a taxpayer who is legally obligated to make the payment, then the 
taxpayer is treated as receiving the payment from the third party and, 
in turn, paying the interest.
    (ii) Examples. The following examples illustrate the rules of this 
paragraph (b)(4):

    Example 1. Payment by employer.  Student C obtains a qualified 
education loan to attend college. Upon Student C's graduation from 
college, Student C works as an intern for a non-profit organization 
during which time Student C's loan is in deferment and Student C 
makes no interest payments. As part of the internship program, the 
non-profit organization makes an interest payment on behalf of 
Student C after the deferment period. This payment is not excluded 
from Student C's income under section 108(f) and is treated as 
additional compensation includible in Student C's gross income. 
Assuming fulfillment of all other requirements of section 221, 
Student C may deduct this payment of interest for Federal income tax 
purposes.
    Example 2. Payment by parent.  Student D obtains a qualified 
education loan to attend college. Upon graduation from college, 
Student D makes legally required monthly payments of principal and 
interest. Student D's mother makes a required monthly payment of 
interest as a gift to Student D. A deduction for Student D as a 
dependent is not allowed on another taxpayer's tax return for that 
taxable year. Assuming fulfillment of all other requirements of 
section 221, Student D may deduct this payment of interest for 
Federal income tax purposes.

    (c) Maximum deduction. In any taxable year beginning before January 
1, 2002, 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
------------------------------------------------------------------------
1998.......................................................       $1,000
1999.......................................................        1,500
2000.......................................................        2,000
2001.......................................................        2,500
------------------------------------------------------------------------

    (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). Section 221 does not allow a deduction for taxpayers with 
modified adjusted gross income of $55,000 or above ($75,000 or above 
for married individuals who file a joint return).

[[Page 25496]]

    (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 United States 
possessions or Puerto Rico). Modified adjusted gross income must be 
determined under this section after taking into account the inclusions, 
exclusions, deductions, and limitations provided by sections 86 (social 
security and tier 1 railroad retirement benefits), 135 (redemption of 
qualified United States savings bonds), 137 (adoption assistance 
programs), 219 (deductible qualified retirement contributions), and 469 
(limitation on passive activity losses and credits), but before taking 
into account the deduction provided by section 221.
    (e) 60-month rule--(1) In general. 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 first day of the month that includes the 
date on which interest payments are first required and ends 60 months 
later, unless the 60-month 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 run regardless of whether the required 
interest payments are actually made. The date on which the first 
interest payment is required 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 (such as loan programs 
under Title IV of the Higher Education Act of 1965 (20 U.S.C. 1070) and 
Titles VII and VIII of the Public Health Service Act (42 U.S.C. 292., 
and 42 U.S.C. 296)) under applicable Federal regulations. For a 
discussion of interest, see paragraph (h) of this section. For special 
rules relating to loan refinancings, consolidated loans, and collapsed 
loans, see paragraph (i) 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, section 221 allows no deduction 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. Section 221 allows a deduction 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 generally is suspended 
for any period when interest payments are not required on a qualified 
education loan because the lender has granted the taxpayer a period of 
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 promissory note contains conditions 
substantially similar to 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, and the borrower satisfies one 
of those conditions. For any qualified education loan, the 60-month 
period is not suspended if under the terms of the loan interest 
continues to accrue while the loan is in deferment or forbearance and 
either--
    (i) In the case of deferment, the taxpayer agrees to pay interest 
currently during the deferment period; or
    (ii) In the case of forbearance, the taxpayer agrees to make 
reduced payments, or payments of interest only, during the forbearance 
period.
    (4) Late payments. A deduction is allowed for a payment of interest 
required in one month but actually made in a subsequent month prior to 
the expiration of the 60-month period. A deduction is not allowed for a 
payment of interest required in one month but actually made in a 
subsequent month after the expiration of the 60-month period. A late 
payment made during a period of deferment or forbearance is treated, 
solely for purposes of determining whether it is made during the 60-
month period, as made on the date it is due.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (e). In the examples, assume that the institution the student 
attends is an eligible educational institution, the loan is a qualified 
education loan and is issued or guaranteed under a federal 
postsecondary education loan program, the student is legally obligated 
to make interest payments under the terms of the loan, the interest 
payments occur after December 31, 1997, but before January 1, 2002, and 
with respect to any period after December 31, 1997, but before January 
21, 1999, the taxpayer elects to apply the rules of this section. The 
examples are as follows:

    Example 1. Payment prior to 60-month period. Student E obtains a 
loan to attend college. The terms of the loan provide that interest 
accrues on the loan while Student E earns his undergraduate degree 
but that Student E is not required to begin making payments of 
interest until six full calendar months after he graduates. 
Nevertheless, Student E voluntarily pays interest on the loan while 
attending college. Student E is not allowed a deduction for interest 
paid during that period, because those payments were made prior to 
the start of the 60-month period. Similarly, Student E would not be 
allowed a deduction for any interest paid during the six month grace 
period after graduation when interest payments are not required.
    Example 2. Deferment option not exercised. The facts are the 
same as in Example 1 except that Student E makes no payments on the 
loan while enrolled in college. Student E 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, Student E enrolls in graduate school on a full-time 
basis. Under the terms of the loan, Student E may apply for 
deferment of the loan payments while enrolled in graduate school. 
However, Student E elects not to apply for deferment and continues 
to make required monthly payments on the loan during graduate 
school. Assuming fulfillment of all other relevant requirements, 
Student E may deduct interest paid on the loan during the 60-month 
period beginning in January 2000, including interest paid while 
enrolled in graduate school.
    Example 3. Late payment, within 60-month period. The facts are 
the same as in Example 2 except that, after the loan enters 
repayment status in January 2000, Student E makes no interest 
payments until March 2000. In March 2000, Student E pays interest 
required for the months of January, February, and March 2000. 
Assuming fulfillment of all other relevant requirements, Student E 
may deduct the interest paid in March for the months of January, 
February, and March because the interest payments are required under 
the terms of the loan and are 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 F's 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. Student F fails to make the required interest payments 
for the months of November and December 2000. In

[[Page 25497]]

January 2001, Student F enrolls in graduate school on a half-time 
basis. Under the terms of the loan, Student F obtains a deferment of 
the loan payments due while enrolled in graduate school. The 
deferment becomes effective January 1, 2001. In March 2001, while 
the loan is in deferment, Student F pays the interest due for the 
months of November and December 2000. Assuming fulfillment of all 
other relevant requirements, Student F may deduct interest paid in 
March 2001, for the months of November and December 2000, because 
the late interest payments are treated, solely for purposes of 
determining whether they were made during the 60-month period, as 
made in November and December 2000.
    Example 5. 60-month period. The terms of Student G's 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, Student G 
enrolls in graduate school on a half-time basis. As permitted under 
the terms of the loan, Student G applies for deferment of the loan 
payments due while enrolled in graduate school. While awaiting 
formal approval from the lender of his request for deferment, 
Student G pays interest due for the month of January 2000. In 
February 2000, the lender approves Student G's request for 
deferment, effective as of January 1, 2000. Assuming fulfillment of 
all other relevant requirements, Student G may deduct interest paid 
in January 2000, prior to his receipt of the lender's approval, even 
though the deferment was retroactive to January 1, 2000. As of 
February 2000, there are 57 months remaining in the 60-month period 
for that loan. Because Student G is not required to make interest 
payments during the period of deferment, the 60-month period is 
suspended. After January 2000, Student G may not deduct any 
voluntary payments of interest made during the period of deferment.
    Example 6. 60-month period. The terms of Student H's loan 
require her 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, Student H 
enrolls in graduate school on a half-time basis. As permitted under 
the terms of the loan, Student H applies to make reduced payments of 
principal and interest while enrolled in graduate school. After the 
lender approves her application, Student H pays principal and 
interest due for the month of January 2000 at the reduced rate. 
Assuming fulfillment of all other relevant requirements, Student H 
may deduct interest paid in January 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 of interest on a loan is due in 
January 1997. Thereafter, interest payments are required on a 
monthly basis. The 60-month period described in paragraph (e)(1) of 
this section for this loan begins on January 1, 1997, the first day 
of the month that includes the date on which the first interest 
payment is required. However, the borrower may not deduct interest 
paid prior to January 1, 1998, under the effective date provisions 
of section 221. Assuming fulfillment of all other relevant 
requirements, 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 
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 as eligible to participate in student aid 
programs administered by the Department, as described in section 
25A(f)(2) and Sec.  1.25A-2(b). 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, a student's cost of attendance is determined by the eligible 
educational institution and includes tuition and fees normally assessed 
a student carrying the same academic workload as the student, 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 are reduced by 
any amount that is paid to or on behalf of a student with respect to 
such expenses and that is--
    (A) A qualified scholarship that is excludable from income under 
section 117;
    (B) An educational assistance allowance for a veteran or member of 
the armed forces 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 amount that is described in section 25A(g)(2)(C) 
(relating to amounts excludable from gross income as educational 
assistance);
    (E) Any otherwise includible amount excluded from gross income 
under section 135 (relating to the redemption of United States savings 
bonds); or
    (F) Any otherwise includible amount distributed from a Coverdell 
education savings account and excluded from gross income under section 
530(d)(2).
    (3) Qualified education loan--(i) In general. A 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 152) of the 
taxpayer at the time the taxpayer incurs the indebtedness;
    (B) 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 
half the normal full-time workload); and
    (C) Paid or incurred within a reasonable period of time before or 
after the taxpayer incurs the indebtedness.
    (ii) Reasonable period. Except as otherwise provided in this 
paragraph (f)(3)(ii), what constitutes a reasonable period of time for 
purposes of paragraph (f)(3)(i)(C) of this section generally is 
determined based on all the relevant facts and circumstances. However, 
qualified higher education expenses are treated as paid or incurred 
within a reasonable period of time before or after the taxpayer incurs 
the indebtedness if--
    (A) The expenses are paid with the proceeds of education loans that 
are part of a federal postsecondary education loan program; or
    (B) The expenses relate to a particular academic period and the 
loan proceeds used to pay the expenses are disbursed within a period 
that begins 90 days prior to the start of that academic period and ends 
90 days after the end of that academic period.
    (iii) Related party. A qualified education loan does not include 
any indebtedness owed to a person who is related to the taxpayer, 
within the meaning of section 267(b) or 707(b)(1). For example, a 
parent or grandparent of the taxpayer is a related person. In addition, 
a qualified education loan does not include 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).
    (iv) Federal issuance or guarantee not required. A loan does not 
have to be issued or guaranteed under a federal

[[Page 25498]]

postsecondary education loan program to be a qualified education loan.
    (v) Refinanced and consolidated indebtedness--(A) In general. A 
qualified education loan includes indebtedness incurred solely to 
refinance a qualified education loan. A qualified education loan 
includes a single, consolidated indebtedness incurred solely to 
refinance two or more qualified education loans of a borrower.
    (B) Treatment of refinanced and consolidated indebtedness. 
[Reserved.]
    (4) Examples. The following examples illustrate the rules of this 
paragraph (f):

    Example 1. Eligible educational institution. University J is a 
postsecondary educational institution described in section 481 of 
the Higher Education Act of 1965. The U.S. Department of Education 
has certified that University J is eligible to participate in 
federal financial aid programs administered by that Department, 
although University J chooses not to participate. University J is an 
eligible educational institution.
    Example 2. Qualified higher education expenses. Student K 
receives a $3,000 qualified scholarship for the 1999 fall semester 
that is excludable from Student K's gross income under section 117. 
Student K receives no other forms of financial assistance with 
respect to the 1999 fall semester. Student K's cost of attendance 
for the 1999 fall semester, as determined by Student K'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 K 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 3. Qualified education loan. Student L 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. Student L uses all the loan 
proceeds to pay qualified higher education expenses incurred within 
a reasonable period of time after incurring the indebtedness. The 
loan is not federally guaranteed. The commercial bank is not related 
to Student L within the meaning of section 267(b) or 707(b)(1). 
Student L's loan is a qualified education loan within the meaning of 
section 221.
    Example 4. Qualified education loan. Student M 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, the lender disburses loan proceeds to 
Student M's college. The college credits them to Student M's account 
to pay qualified higher education expenses for the 1999 fall 
semester, which begins on August 23, 1999. On January 25, 2000, the 
lender disburses additional loan proceeds to Student M's college. 
The college credits them to Student M's account to pay qualified 
higher education expenses for the 2000 spring semester, which began 
on January 10, 2000. Student M's qualified higher education expenses 
for the two semesters are paid within a reasonable period of time, 
as the first loan disbursement occurred within the 90 days prior to 
the start of the fall 1999 semester, and the second loan 
disbursement occurred during the spring 2000 semester.
    Example 5. Qualified education loan. The facts are the same as 
in Example 4, except that in 2001 the college is not an eligible 
educational institution because it loses its eligibility to 
participate in certain federal financial aid programs administered 
by the U.S. Department of Education. The qualification of Student 
M's loan, which was used to pay for qualified higher education 
expenses for the 1999 fall and 2000 spring semesters, as a qualified 
education loan is not affected by the college's subsequent loss of 
eligibility.
    Example 6. Mixed-use loans. Student N signs a promissory note 
for a loan that is secured by Student N's personal residence. 
Student N will use part of the loan proceeds to pay for certain 
improvements to Student N's residence and part of the loan proceeds 
to pay qualified higher education expenses of Student N's spouse. 
Because Student N obtains the loan not 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 allowable under another 
provision of Chapter 1 of the Internal Revenue Code. No deduction is 
allowed under this section for any amount for which an exclusion is 
allowable under section 108(f) (relating to cancellation of 
indebtedness).
    (h) Interest--(1) In general. Amounts paid on a qualified education 
loan are deductible under section 221 if the amounts are interest for 
Federal income tax purposes. For example, interest includes--
    (i) Qualified stated interest (as defined in Sec.  1.1273-1(c)); 
and
    (ii) Original issue discount, which generally includes capitalized 
interest. For purposes of section 221, capitalized interest means any 
accrued and unpaid interest on a qualified education loan that, in 
accordance with the terms of the loan, is added by the lender to the 
outstanding principal balance of the loan.
    (2) Operative rules for original issue discount--(i) In general. 
The rules to determine the amount of original issue discount on a loan 
and the accruals of the discount are in sections 163(e), 1271 through 
1275, and the regulations thereunder. In general, original issue 
discount is the excess of a loan's stated redemption price at maturity 
(all payments due under the loan other than qualified stated interest 
payments) over its issue price (the amount loaned). Although original 
issue discount generally is deductible as it accrues under section 
163(e) and Sec.  1.163-7, original issue discount on a qualified 
education loan is not deductible until paid. See paragraph (h)(3) of 
this section to determine when original issue discount is paid.
    (ii) Treatment of loan origination fees by the borrower. If a loan 
origination fee is paid by the borrower other than for property or 
services provided by the lender, the fee reduces the issue price of the 
loan, which creates original issue discount (or additional original 
issue discount) on the loan in an amount equal to the fee. See Sec.  
1.1273-2(g). For an example of how a loan origination fee is taken into 
account, see Example 2 of paragraph (h)(4) of this section.
    (3) Allocation of payments. See Sec. Sec.  1.446-2(e) and 1.1275-
2(a) for rules on allocating payments between interest and principal. 
In general, these rules treat a payment 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, and second as a payment of principal. The 
characterization of a payment as either interest or principal under 
these rules applies regardless of how the parties label the payment 
(either as interest or principal). Accordingly, the taxpayer may deduct 
the portion of a payment labeled as principal that these rules treat as 
a payment of interest on the loan, including any portion attributable 
to capitalized interest or loan origination fees.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (h). In the examples, assume that the institution the student 
attends is an eligible educational institution, the loan is a qualified 
education loan, the student is legally obligated to make interest 
payments under the terms of the loan, and any other applicable 
requirements, if not otherwise specified, are fulfilled. The examples 
are as follows:

    Example 1. Capitalized interest. Interest on Student O's 
qualified education loan accrues while Student O is in school, but 
Student O is not required to make any payments on the loan until six 
months after he graduates or otherwise leaves school. At that time, 
the lender capitalizes all accrued but unpaid interest and adds it 
to the outstanding principal amount of the loan. Thereafter, Student 
O is required to make monthly payments of interest and principal on 
the loan. The interest payable on the loan, including the 
capitalized interest, is original issue discount. 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 O may deduct any payments that

[[Page 25499]]

Sec.  1.1275-2(a) treats as payments of interest, including any 
principal payments that are treated as payments of capitalized 
interest. See paragraph (h)(3) of this section.
    Example 2. Allocation of payments. The facts are the same as in 
Example 1 of this paragraph (h)(4), except that, in addition, the 
lender charges Student O a loan origination fee, which is not for 
any property or services provided by the lender. Under Sec.  1.1273-
2(g), the loan origination fee reduces the issue price of the loan, 
which reduction increases the amount of original issue discount on 
the loan by the amount of the fee. The amount of original issue 
discount (which includes the capitalized interest and loan 
origination fee) that accrues each year is determined under section 
Sec.  1272 and Sec.  1.1272-1. In effect, the loan origination fee 
accrues over the entire term of the loan. Because the loan has 
original issue discount, the payment ordering rules in Sec.  1.1275-
2(a) must be used to determine how much of each payment is interest 
for federal tax purposes. See paragraph (h)(3) of this section. 
Under Sec.  1.1275-2(a), each payment (regardless of its designation 
by the parties as either interest or principal) generally is treated 
first as a payment of original issue discount, to the extent of the 
original issue discount that has accrued as of the date the payment 
is due and has not been allocated to prior payments, and second as a 
payment of principal. 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 O may 
deduct any payments that the parties label as principal but that are 
treated as payments of original issue discount under Sec.  1.1275-
2(a). The 60-month period does not begin in the month in which the 
lender charges Student O the loan origination fee.

    (i) Special rules regarding 60-month limitation--(1) Refinancing. A 
qualified education loan and all indebtedness incurred solely to 
refinance that loan constitute a single loan for purposes of 
calculating the 60-month period described in paragraph (e)(1) of this 
section.
    (2) 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 latest 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.
    (3) Collapsed loans. A collapsed loan is two or more qualified 
education loans of a single taxpayer that constitute a single qualified 
education loan for loan servicing purposes and for which the lender or 
servicer does not separately account. For a collapsed loan, the 60-
month period described in paragraph (e)(1) of this section begins on 
the latest 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.
    (4) Examples. The following examples illustrate the rules of this 
paragraph (i):

    Example 1. Refinancing.  Student P obtains a qualified education 
loan to pay for an undergraduate degree at an eligible educational 
institution. After graduation, Student P is required to make monthly 
interest payments on the loan beginning in January 2000. Student P 
makes the required interest payments for 15 months. In April 2001, 
Student P borrows money from another lender exclusively to repay the 
first qualified education loan. The new loan requires interest 
payments to start immediately. At the time Student P must begin 
interest payments on the new loan, which is a qualified education 
loan, there are 45 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 Q 
obtains four separate qualified education loans from Lender R. The 
loans enter repayment status, and their respective 60-month periods 
described in paragraph (e)(1) of this section begin, in July, 
August, September, and December of 1999. After all of Student Q's 
loans have entered repayment status, Lender R informs Student Q that 
Lender R will transfer all four loans to Lender S. Following the 
transfer, Lender S treats the loans as a single loan for loan 
servicing purposes. Lender S sends Student Q a single statement that 
shows the total principal and interest, and does not keep separate 
records with respect to each loan. With respect to the single 
collapsed loan, the 60-month period described in paragraph (e)(1) of 
this section begins in December 1999.

    (j) Effective date. This section is applicable to interest due and 
paid on qualified education loans after January 21, 1999, if paid 
before January 1, 2002. Taxpayers also may apply this section to 
interest due and paid on qualified education loans after December 31, 
1997, but before January 21, 1999. This section also applies to 
interest due and paid on qualified education loans in a taxable year 
beginning after December 31, 2010.

0
3. Section 1.6050S-3 is amended by revising paragraphs (d)(1)(iii)(B) 
and (e)(1) to read as follows:


Sec.  1.6050S-3  Information reporting for payments of interest on 
qualified education loans.

* * * * *
    (d) * * * (1) * * *
    (iii) * * *
    (B) In the case of qualified education loans made before September 
1, 2004, for which the payee does not report payments of interest other 
than stated interest, state that the payor may be able to deduct 
additional amounts (such as certain loan origination fees and 
capitalized interest) not reported on the statement;
* * * * *
    (e) Special rules--(1) Transitional rule for reporting of loan 
origination fees and capitalized interest--(i) Loans made before 
September 1, 2004. For qualified education loans made before September 
1, 2004, a payee is not required to report payments of loan origination 
fees or capitalized interest or to take such payments into account in 
determining the $600 amount for purposes of paragraph (a)(1) of this 
section.
    (ii) Loans made on or after September 1, 2004. For qualified 
education loans made on or after September 1, 2004, a payee is required 
to report payments of interest as described in Sec.  1.221-1(f). Under 
Sec.  1.221-1(f), interest includes loan origination fees that 
represent charges for the use or forbearance of money and capitalized 
interest. Under this paragraph (e)(1)(ii), a payee shall take such 
payments of interest into account in determining the $600 amount for 
purposes of paragraph (a)(1) of this section. For purposes of this 
section and section 6050S, interest (including capitalized interest and 
loan origination fees) is treated as received, and is reportable, in 
the year the interest is treated as paid under the allocation rules in 
Sec.  1.221-1(f)(3).
    See Sec.  1.221-1(f) for rules relating to capitalized interest, 
and Sec.  1.221-1(f)(2)(ii) for rules relating to loan origination 
fees, on qualified education loans.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: April 27, 2004.
Gregory F. Jenner,
Acting Assistant Secretary of the Treasury.
[FR Doc. 04-10359 Filed 5-6-04; 8:45 am]
BILLING CODE 4830-01-P