The Twists and Turns of Deducting Interest Expenses

Mar 30th 2017
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Are you paying interest on a mortgage, another loan, or credit card debt? Depending on the nature of the expense, all of the interest may be deductible on your federal tax return, some may be deductible, or none may be deductible. Plus, the situation becomes even trickier if loan proceeds are commingled.

Although the tax law defines “interest” in a variety of ways, in this article we will focus mainly on interest expenses you can deduct on lines 10-15 on Schedule A of Form 1040.

The biggest deductible interest expense for many taxpayers is “qualified residence interest” (i.e., mortgage interest). Under current law, a taxpayer may deduct mortgage interest on acquisition debt of up to $1 million and home equity debt up to $100,000 on a qualified residence. This includes debts on your principal residence and one other home, like a vacation home.

For this purpose, “acquisition debt” is defined as a debt incurred for the construction, improvement, or purchase of a home. Any other home debt, such as a home equity loan or a line of credit, may qualify as “home equity debt.” In either case, the debt must be secured by a qualified residence.

The deduction for mortgage interest includes “points” you must pay to acquire a home at a favorable interest rate. (Each point is equal to 1 percent of the mortgage amount.) However, if you pay points on a refinanced mortgage, the points must be amortized over the life of the loan.

The IRS also allows you to deduct investment interest expenses up to the amount of your net investment income. Typically, you might incur investment interest expenses when you buy stock on margin or otherwise borrow money to make investments.

For this purpose, and not other tax law provisions, “net investment income” is defined as your investment income reduced by investment expenses other than interest. Investment income includes such items as:

  • Interest
  • Dividends
  • Royalties
  • Gains from sales of investment property
  • Income from annuities

However, long-term capital gains and dividends qualifying for beneficial tax status generally don’t count as investment income under this rule. If you elect to include long-term capital gains and dividends in the calculation, you must forego the preferential tax treatment for those items.

In addition, certain other limits apply to passive activity interest expenses. Generally, your deduction for expenses from passive activities where you do not materially participate in the activity is limited to the amount of your passive activity income, subject to special rules (e.g., a partial deduction may be available to certain real estate investors). 

Most types of personal interest expenses are not deductible on your tax return. This includes:

  • Interest paid on a loan to purchase a car for personal use.
  • Credit card and installment interest incurred for personal expenses.
  • Points (if you’re a seller), service charges, credit investigation fees, and interest relating to tax-exempt income, such as interest to purchase or carry tax-exempt securities.

Note that there is a limited above-the-line deduction for interest paid on student loans. For 2017, you can deduct interest you paid up to $2,500, but this deduction is phased out, based on your income.

To avoid complex calculations for allocating interest expenses, keep your loan proceeds in separate accounts. For instance, don’t mix up funds borrowed for personal reasons with amounts being used for home improvements.

Congress has chipped away at the interest deduction in the past, and other changes may be forthcoming as part of a tax reform package. Keep a close watch as tax reform talks in Washington begin to heat up.

Related articles:

Don’t Overlook the Tax Deduction for Mortgage Points
Limited Write-Offs for Student Loan Interest

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