- Learn about interest categories.
- Find information regarding category deductibility.
- Learn about interest tracing rules.
A frequent question that arises when borrowing money is whether or not the interest will be tax deductible. That can be a complicated question, and unfortunately, not all interest an individual pays is deductible. The rules for deducting interest vary, depending on whether one uses the loan proceeds for personal, investment, or business activities.
Which kinds of interest are deductible?
Interest expense can fall into any of the following categories:
Personal interest is not deductible. Typically, this includes interest from personal credit card debt, personal car loan interest, home appliance purchases, etc.
Investment interest is interest paid on debt incurred to purchase investments such as land, stocks, mutual funds, etc. However, interest on debt to acquire or carry tax-free investments is not deductible at all. The annual investment interest deduction is limited to net investment income. Net investment income equals the total taxable investment income reduced by investment expenses (other than expenses related to investments that produce non-taxable income). Also: Only taxpayers who itemize their deductions may claim the investment interest deduction.
Home mortgage interest
Home mortgage interest includes the interest on debt to purchase, construct or substantially improve a taxpayer’s principal home or second home. We call this type of loan an acquisition debt. For the interest to be deductible, the debt must be secured by the home purchased, constructed, or substantially improved.
A secured debt is one in which the taxpayer signs a mortgage, deed of trust, or land contract that makes their ownership in a qualified home security for payment of the debt; provides, in case of default, that the home could satisfy the debt; and is recorded under any state or local law that applies. In other words, if the taxpayer can't pay the debt, their home can then serve as a payment to the lender to satisfy the debt.
o For Debt Incurred Before 12/16/2017 – the debt for which the interest is deductible is limited to $1,000,000 ($500,000 for married separate).
o For Debt Incurred After 12/15/2017 – the debt for which the interest is deductible is limited to $750,000 ($375,000 for married separate).
Passive activity interest
Passive activity interest includes interest on debt that's for business or income-producing activities in which the taxpayer doesn’t “materially participate.” It is generally deductible only if income from passive activities exceeds expenses from those activities. The most common passive activities are probably real estate rentals. Consider rental real estate activities. There is a special passive loss allowance of up to $25,000 for taxpayers who are active but not necessarily material participants in the rental. The $25,000 phases out for taxpayers with adjusted gross income between $100,000 and $150,000.
Trade or business interest
Trade or business interest includes interest on debts that are for activities in which a taxpayer materially participates. This type of interest can generally be deducted in full as a business expense.
Interest deductions have a variety of limits. So, the IRS provides special rules to allocate interest expenses among the categories. We generally base these “tracing rules” on the use of the loan proceeds. Thus we allocate interest expense on a debt in the same manner as the allocation of the debt to which the interest expense relates. We allocate debt by tracing disbursements of the debt proceeds to specific expenditures, i.e., “follow the money.”
These tracing rules, combined with the restrictions associated with the various categories of interest, can create some unexpected results. Here are some examples:
A taxpayer takes out a loan secured by his rental property and uses the proceeds to refinance the rental loan and buy a car for personal use. The taxpayer must allocate interest expense on the loan between rental interest and personal interest for the purchase of the car. Even though the business property secures the loan, taxpayers cannot deduct the personal loan interest portion.
The taxpayer borrows $50,000 secured by his home to use in his contracting business. He deposits the $50,000 in the business checking account and used it to make a downpayment on construction equipment.
The taxpayer owns a rental property free and clear. He wants to purchase a home to use as his personal residence. So, he obtains a loan on the rental to purchase the home. Under the tracing rules, the taxpayer must trace the use of the funds to their use. As the debt was not used to acquire the rental, the interest on the loan cannot be deducted as rental interest. The funds can be traced to the purchase of the taxpayer’s home. However, for interest to be deductible as home mortgage interest, the debt must be secured by the home, which it is not. Result: the interest is not deductible anywhere.
As you can see, you must plan your financing moves carefully, especially when you use the equity in one asset to acquire another. Need assistance in applying the various interest limitations and tracing rules to ensure you don’t inadvertently get some unexpected results? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.