Unqualified education expense versus income

Scholarships that pay for or are allocated to  qualified educational expenses (QEE - tuition, fees, books and other course materials) is tax free.  Scholarship amounts that exceed QEE is taxable income, on the student’s tax return.

It doesn't matter what you actually used the scholarship money for. What matters is whether you had qualified education expenses (QEE) that you could allocate that money to. It may be best explained by example. Box 5, of the 1098-T is $6000. Box 1 is $4000. In addition, you have $1000 for books and a computer  On the surface, you have $1000 of taxable scholarship to report, as income.  But, you can choose to allocate the money differently, for the best tax effect.  Read on for the most common scenario.

There is a tax “loop hole” available to claim an education credit, for the parents of students on scholarship. The student reports all his scholarship, up to the amount needed to claim the American Opportunity Credit (AOC), as income on his return. That way, the parents  (or himself, if he is not a dependent) can claim the tuition credit on their return. They can do this because that much tuition was no longer paid by "tax free" scholarship.  You cannot do this  if the conditions of the grant are that it be used to pay for qualified expenses.

Using an example: Student has $10,000 in box 5 of the 1098-T and $8000 in box 1. At first glance he/she has $2000 of taxable income and nobody can claim the American opportunity credit. But if she reports $6000 as income on her return, the parents can claim $4000 of qualified expenses on their return.

Books and computers are also qualifying expenses for the AOC. So, extending the example, the student had another $1000 in expenses for those course materials, paid out of pocket. She would only need to report $5000 of taxable scholarship income, instead of $6000.