I’ve previously discussed in the detail the benefits and importance of consolidating federal student loans into a Direct consolidation loan as soon as possible after graduating.
One side perk of doing so is that most people will also max out their student loan interest deduction for that tax year regardless of whatever actual monthly payments you make on your loan.
That’s because several things are included as interest in addition to obvious actually paying interest on the loan with monthly payments. From IRS Pub 970:
Capitalized interest. This is unpaid interest on a student loan that is added by the lender to the outstanding principal balance of the loan. Capitalized interest is treated as interest for tax purposes and is deductible as payments of principal are made on the loan. No deduction for capitalized interest is allowed in a year in which no loan payments were made.
Interest on refinanced and consolidated student loans. This includes interest on a loan used solely to refinance a qualified student loan of the same borrower. It also includes a single consolidation loan used solely to refinance two or more qualified student loans of the same borrower.
So, for most medical students, consolidating after graduation will automatically max out the deduction for that tax year, even if you end up with $0 IDR payments under IBR/PAYE/REPAYE and pay no actual interest yourself.
The reason for this is that interest accumulates on all unsubsidized loans while in school, which normally capitalizes at the end of grace period. Consolidating creates a new loan that “pays” off all the interest on your former loans. It would be an extremely lucky student who borrows so little as to accrue less than $2,500 (the max deduction) in interest over multiple years of school.
Make sure to download your 1098-E form from your loan servicer if they don’t send you one in the mail, as this document demonstrates the amount of interest paid. Your tax software like Turbotax or accountant will need this.
Remember, however, that there is a phase-out for this deduction with rising income starting at $65k/yr single and $130k/yr married with no deduction for incomes above $80k/$160k. Your tax software will do this for you automatically.
Big hat tip to Sotirios and Dalton from Doctored Money for bringing this up the other day.
Here’s an issue that has come up. I read your book on student loans which was very helpful. I plan to follow your advice and do the RePaye program, and consolidate immediately with no grace period, and file taxes with no income. I just graduated and applied to consolidate my loans the day after graduation, and checked the box for no grace period. My servicer told me on the phone after I applied that my direct fed unsubsidized loans have a mandatory grace period for 6 months and that the consolidation application would not process until after the 6 month grace period had ended. This “mandatory grace period” does not correlate with everything I have read online (including from you), and would mess up a lot of the benefits you have laid out. Have you heard of this? I am hoping the woman on the phone was wrong or that it will correct itself once my status on the federal loan website updates from “full time” to “graduated”
They are wrong. The grace period is mandatory for your current loans. AND the classic/typical handling has been for the consolidation to trigger at the end of grace period.
However, there is no mandatory grace period for consolidation loans, and you do not have to wait until the end of grace period to consolidate.
Again, that servicer rep is definitely wrong. The loan status will have to be graduated in order for it to go through, there isn’t much point to jumping the gun until then.
So call again when the status is corrected and see what’s up. If you get another stupid answer, ask for a supervisor. I can see a scenario where you could have re-file the consolidation if it somehow got processed (but incorrectly), but I think once the status is updated the right person will be able take care of it. It’s definitely worth another phone call at that time.
Good to know! Thank you for the clarification and timely response.
Would refinancing student loan in 2021 effectively do the same and “pay” off all the interest on my former loan and allow me to deduct the full $2500 in 2021 even if I made no payments this year.
That’s the idea.