Dear Dr. Don, My wife's parents are struggling financially, and we would like to take over her parents' student loan obligation that they incurred for her. Is there a way for us to take over the loans and also get the tax benefits? We just bought a house, so I'm not sure that we could qualify for an unsecured loan for the loan balance of approximately $75,000.
Thanks, -- Tom Takeover
Dear Tom I think it's great that you and your wife are going to help out her parents by taking over their student loan payments on the debt they took out to finance her education.
However, for you and your wife to claim the tax deductions for the student loan interest, the loans must be in your names. That's because the Internal Revenue Service requires that you be legally obligated to pay interest on a qualified student loan to take the deduction. There's no easy way to finance the student loan debt in your names. The IRS states that, "If you are the person legally obligated to make interest payments and someone else makes a payment of interest on your behalf, you are treated as receiving the payments from the other person and, in turn, paying the interest."
Paying the loans for her parents could trigger gift-tax implications, but the loan payments should fall within the annual exclusion for gifting, which is $13,000 in the 2012 tax year. You can gift up to $13,000 to her father and another $13,000 to her mother under the annual exclusion. Married couples can double that amount by splitting gifts. Talk with your tax professional if you're planning to gift more than the annual exclusion amount.
The student loan interest deduction is, generally speaking, the smaller of $2,500 or the actual student loan interest expense. The deduction is phased out for people at higher levels of modified adjusted gross income, or MAGI.
I'd suggest taking over responsibility for the payments, and if the tax deduction is that important to you, ask her parents to contribute an amount equal to your lost tax break. If you're in the 25% marginal federal income tax bracket, a lost $2,500 deduction means you pay an extra $625 in federal income tax.
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