Taxation of Grants

• If you receive grants or scholarships that cover all of your educational expenses, the IRS treats those funds as tax-free. This means that even though you don't work for the money or have to pay it back, you still don't need to report the income on your tax return or pay any tax on it. These grants are only tax-free if you spend the money on IRS-approved expenses. These includes tuition, fees, books, supplies and equipment. However, the IRS also requires you to be working toward a degree in order to retain the grant's tax-free status. Therefore, if you receive a scholarship to take a one-time class, then you must report the grants and scholarships on your tax return as taxable income.
  
  

Using Tax-Free Funds

• Both the American opportunity and lifetime learning credits are not available to you when you pay all of your school expenses with tax-free grants and scholarships. This is because the credits only cover payments that you make with your own funds, including the funds you receive from a student loan or funds from inheritances and gifts you receive. The credits are also available to the taxpayer who claims you as a dependent if he pays for all of your school expenses in the same way.
  
  

Grant Fund Exceptions

• There are two ways that you can receive grants and still claim one of the tax credits. If you receive your grants to take continuing education courses or for professional skills training classes that don't lead to a degree, then your grants are no longer tax-free, meaning you must report them on your tax return. When your grants are taxable, you qualify to claim the lifetime learning credit, but not the American opportunity credit. Alternatively, if your tax-free grants only cover your tuition and fees, then you will qualify to claim the American opportunity credit for the costs you incur to purchase the books, supplies and equipment you need for your courses. However, under the lifetime learning credit, these expenses only qualify if the school requires direct payment for them, and of course, your grants don't cover them.
  
  

Other Credit Requirements

• In addition to determining whether or not your grants are tax-free, there are other criteria you must satisfy for the credits. To claim the American opportunity credit, you must be in one of the first four years of post-secondary education and be working toward a degree or other recognized credential. In addition, you must enroll at least half-time for one academic period during the year. Alternatively, you can claim the lifetime learning credit, which only requires that you attend a recognized post-secondary institution and take at least one course during the year.