IRC Section 117 does not provide tracing rules for spending a scholarship. If the cost of attendance exceeds the scholarship/grant received, a student could state that the scholarship/grant was used for room and board, and other funds were used to qualified tuition expenses. The scholarship/grant used to pay for room and board would then be taxable to the child. However, this would leave tuition expenses available to claim either the American Opportunity or Lifetime Learning tax credit.
Larry received a grant of $6,000 from the college he was going to attend. The college charges $6,000 for tuition and fees, $1,800 for books and supplies, and $5,000 for room and board. If the college’s student payment ordering policy requires the $6,000 grant to be applied first to tuition and fees, the parents will not have any “qualified” expenses for the American Opportunity Credit. The $6,000 tax-free grant would reduce the $6,000 of tuition and fees to zero. However, if the college’s payment ordering policy allowed the $6,000 grant to be applied first to room and board and books and supplies, the parents would be able to claim the $6,000 of tuition and fees as a “qualifying” expense for the American Opportunity Credit. However, in this situation, Larry would have $5,000 in taxable income. Since grants and scholarships are tax-free only to the extent used for tuition, fees, books, supplies, and equipment, the $5,000 portion of the grant which was applied to the room and board would be considered taxable income to the student. The income would be considered “earned income.” However, it would not be subject to social security tax.
By using scholarships to pay room and board, it may enable you to claim the American Opportunity ($2,500) or the Lifetime Learning ($2,000) tax credit.