Good question and the answer is as follows:
The interest is deductible when paid. The person that told you it is deductible without actually paying it is incorrect. All individual tax payers are considered cash basis, meaning that expenses are deductible when paid and income is recognized as received.
In your situation, you have not paid the $2,500 and it is pretty clear that the Service would send you a notice if you tried to deduct the amount. Furthermore, you will receive a 1099-INT that shows the amount of student loan interest paid. Capitalization of interest to a loan will not give get you this 1099 since the interest will be added to principle. As such, in order to get this capped interest as a deduction, you will have to pay the amount. Make sure this posts to your account in 2006 because otherwise you will not receive an accurate 1099 and your deduction will be in jeopardy. It is an above the line deduction, so you will get a dollar for dollar reduction of your Adjusted Gross income for interest payments you make.
This is what BNA portfolio taxes has to say about this situation...
1.Treatment of Capitalized Interest and Certain Fees
In general amounts paid on qualified education loans are deductible under §221 if the amounts are interest for federal income tax purposes, including qualified stated interest and original issue discount.1370
1370Regs. §§1.221-1(f)(1), -2(h)(1).
Original issue discount generally includes capitalized interest, which for §221 purposes means any accrued and unpaid interest on a qualified education loan that is added by the lender to the loan's outstanding balance, in accordance with the terms of the loan.1371 The rules for determining the amount of original issue discount on a loan and the accruals of the discount are discussed in §§163(e) and 1271-1275. Generally, original issue discount is the excess of all payments due under the loan other than qualified stated interest payments (the stated redemption price at maturity) over the amount loaned (the issue price). Note that original issue discount is generally deductible as it accrues under §163(e); however, original discount on a qualified education loan is not deductible until paid.1372
Loan origination fees (other than any fees for services) paid by the borrower reduces the issue price of the loan, which creates original issue discount (or additional original issue discount) on the loan equal to the fee.1373
1373Regs. §§1.221-1(f)(2)(ii), -2(h)(2)(ii). See Regs. §§1.446-2(e) and 1.1275-2(a) for rules on how to allocate payments between interest and principal. In general, under these rules, a payment (regardless of its label) is treated first as a payment of interest to the extent of interest that has accrued and remains unpaid as of the date payment is due, second, as a payment of any loan origination fees or capitalized interest, until such amounts have been reduced to zero, and third, as a payment of principal. Regs. §§1.221-1(f)(3), -2(h)(3).
The following examples illustrate the above rules.
Example 1. Capitalized interest. Interest on student S's loan accrued while S is in school but S is not required to make payments on the loan until six months after S graduates or until S otherwise leaves school. During that time, the lender capitalizes all accrued but unpaid interest and adds it to the loan's outstanding principal amount. The interest payable on the loan, including the capitalized interest, is original issue discount; thus, in determining the total interest amount deductible by S each taxable year, S may deduct any payments that Regs. §1.1275-2(a) treats as interest payments, including any principal payments that are treated as payments of capitalized interest.1374
Hope this helps.
