Interest Expenses
Taxpayers are allowed a deduction for certain interest paid or accrued during the tax year. Interest is defined as an amount paid for the use of borrowed funds. The type and amount of the deduction depends on the purpose for which the money is borrowed. Interest on loans for business, rent, and royalty activities is deducted for AGI and is covered in Chapter 7, Income: Self-Employment, Rental, Partnership, and Other. Certain interest on loans for personal purposes is deductible as an itemized deduction. The following types of personal interest are deductible:
Qualified residence interestqualified residence interestInterest on a loan (up to $1 million for married filing joint) used to purchase a first or second home. (mortgage interest)
Investment interestinvestment interestInterest paid on a loan, the proceeds of which were used to buy investments.
Certain interest associated with a passive activity
Interest on other loans is referred to as consumer interest and is not deductible. Consumer interest includes interest on any loan the proceeds of which are used for personal purposes, such as bank charge-card interest, finance charges, and automobile loan interest. Interest on loans used to acquire assets generating tax-exempt income is also not deductible.
Example
Pam purchased Elk Grove City bonds with the proceeds of a $15,000 loan. During the year, Pam paid $689 in interest on the loan. She received $750 in interest on the bonds during the year. Pam would not be able to deduct the $689 as investment interest since the interest received on the bonds is not taxable.
The following items are not considered “interest” and, therefore, are not deductible:
Service charges
Credit investigation fees
Loan fees other than “pointspointsPercentage (e.g., 1 point = 1%) of the loan charged by the lender that is an additional interest charge.” discussed below.
Interest paid to carry single premium life insurance
Premium on convertible bonds
To deduct interest on a debt, the taxpayer must be legally liable for the debt. No deduction is allowed for payments made for another’s obligation, where the taxpayer is not liable for payment. Also, both the lender and the borrower must intend for the loan to be repaid.
Example
Phyllis makes a payment on her son’s home mortgage since her son is unable to make the current payment. Phyllis cannot deduct the interest included in the mortgage since the mortgage is not her obligation. Phyllis’s son cannot deduct the interest since he did not make the payment.
Example
Ray loans his daughter $25,000 to start a business. The daughter is 18 years old and has no real business education or experience. As a result, no note is signed and no repayment date is mentioned. Since, in all likelihood, a true debtor-creditor relationship is not created, any interest paid by the daughter is not deductible.
Most taxpayers are cash-basis taxpayers but are required to use the accrual basis for deducting prepaid interest. Prepaid interest must be capitalized and the deduction spread over the life of the loan. This requirement does not apply to points paid on a mortgage loan for purchasing or improving a taxpayer’s principal residence, provided points are customarily charged and they do not exceed the normal rate. Such points paid on a mortgage for the purchase of a personal residence may be deducted in the year they are paid.
Points paid to refinance a home mortgage are not deductible when paid, but must be capitalized and the deduction spread over the life of the loan. Points charged for specific loan services, such as the lender’s appraisal fee and other settlement fees, are not deductible.
Example
On August 1, Ronda, a cash-basis taxpayer, obtains a six-month loan of $800,000 on a new apartment building. On August 1, Ronda prepays $60,000 interest on the loan. She must capitalize the prepaid interest and deduct it over the six-month loan period. Therefore, her interest deduction for this tax year is $50,000 (5 months × $60,000/6 months).
No deduction has been available for consumer (personal) interest, such as interest on credit cards and loans for personal automobiles since 1991. Qualified residence interest, however, is a type of personal interest specifically allowed as a deduction.
The term “qualified residence interest” is the sum of the interest paid on “qualified residence acquisition debt” plus “qualified home equity debt.” The aggregate amount of qualified acquisition debt may not exceed $1,000,000 ($500,000 for married filing separately), and the aggregate amount of qualified home equity debt may not exceed $100,000 ($50,000 for married filing separately). Thus, the total amount of acquisition and home equity debt on the taxpayer’s residence may not exceed $1,100,000 ($550,000 for married filing separately).
Acquisition debt is debt secured by the taxpayer’s principal or second residence incurred in acquiring, constructing, or substantially improving that residence. Refinanced debt is treated as acquisition debt only to the extent it does not exceed the principal amount of acquisition debt immediately before the refinancing. The term “home equity debt” is defined as debt secured by the taxpayer’s principal or second residence, and which is not acquisition debt. Interest on qualifying home equity debt is deductible even if the proceeds are used for personal purposes.
Example
Rob’s residence has a FMV of $800,000. The first mortgage of $425,000 was used to buy the house five years ago. This year, Rob borrowed $130,000 on a second mortgage secured by the house to buy a Porsche and take a vacation. The interest paid on the first mortgage is fully deductible, but interest on only $100,000 of the second mortgage is deductible. Assume Rob pays $15,600 of interest on the first mortgage and $7,800 is paid on the second mortgage. Rob’s mortgage interest deduction is $21,600, and the remainder is nondeductible personal interest computed as follows:
| Interest on acquisition debt | $15,600 |
| Interest on home equity debt: $7,800 × $100,000/$130,000 | $6,000 |
| Mortgage interest deduction allowed | $21,600 |
When a home buyer invests less than 20% of the home purchase price as a down payment, a mortgage insurance premiummortgage insurance premiumWhen the buyer of a home invests less than 20% as a down payment, mortgage insurance is required, and the buyer pays the premium. is charged. For insurance contracts written after January 1, 2007, “qualified mortgage insurance” premiums will be deductible if the insurance is provided by the Veterans Administration, the Federal Housing Administration, or the Rural Housing Administration and private mortgage insurance (as defined in section 2 of the Homeowners Protection Act of 1998 as in effect on December 20, 2006). The amount deductible will be reduced by 10% for every $1,000 ($500 for married filing separately) by which AGI exceeds $100,000.
Congress passed a provision limiting the deduction of investment interestinvestment interestInterest paid on a loan, the proceeds of which were used to buy investments. expense to prevent abuses by high-income taxpayers. This provision limits the amount of deductible interest on loans that finance investments. The investment interest deduction is limited to the taxpayer’s net investment income. Net investment income is income, such as dividends and interest, less investment expenses other than interest. Special rules apply to dividends and capital gains included as investment income due to their preferential tax rates. The general rule is that they may only be included as investment income if the taxpayer chooses to calculate tax on them at ordinary income rates. Any disallowed interest expense is carried over and may be deducted in succeeding years, but only to the extent that the taxpayer’s net investment income exceeds investment interest for the year.
Example
Ross borrowed $125,000 at 10% interest on January 1. He used the proceeds to buy an unimproved real estate lot for $90,000 and bought a $35,000 certificate of deposit. During the year, the certificate of deposit pays interest of $2,050. Ross incurs expenses attributable to the investment property of $500. Of the $12,500 (10% of $125,000) interest incurred, $1,550 is deductible. The deduction is computed as follows:
| Net investment income | |
|---|---|
| Investment income | $2,050 |
| Less: Investment expenses | $500 |
| Interest deductible | $1,550 |
The unused deduction of $10,950 ($12,500 – $1,550) is carried forward and may be used as an interest deduction in future years, subject to the net investment income limitation.
Go to Publication 17 and read Chapter 23: Interest Expense.
Questions and Problems
Which of the following is deductible as interest on Schedule A?
Loan fees that are not “points”
Service charges
Investment interest expense, subject to the net investment income limitation
Interest on loans to finance tax-exempt bonds
None of the above are deductible as interest.
Kellin’s mother defaults on a home loan, and Kellin pays $800 in loan payments, including $275 in interest. Kellin is not legally obligated on the loan. What amount, if any, may Kellin claim as an itemized deduction? $__________
Klaus borrows $300,000 to invest in bonds. During the tax year, his interest on the loan is $30,000. Klaus’s interest income from the bonds is $10,000.
Calculate Klaus’s itemized deduction for investment interest for this year. $__________
Is Klaus entitled to a deduction in future years? Explain. ____________________________________________________
Laura paid the following amounts for interest during the tax year.
Item Amount ($) Qualified interest on home mortgage 7,600 Auto loan interest 1,100 Points on mortgage for acquisition of personal residence 400 Service charge on checking account 65 Visa card interest 630 Total 9,795 Complete the Interest You Paid section of Schedule A for Laura. What is the total interest that Laura can deduct? $__________
Lea and Leo purchased their personal residence nine years ago for $250,000. For the current year, they have a $90,000 first mortgage on their home, on which they paid $6,600 in interest. They also have a home equity loan secured by their home with an average balance for the year of $120,000 and paid interest of $14,000. Calculate the amount of their interest deduction.
Qualified residence acquisition debt interest: $__________
Qualified home equity debt interest: $__________
Mike paid the following amounts of interest during the tax year.
Item Amount ($) Interest on Arlington, VA residence, loan balance is $560,000 19,300 Interest on Lake Tahoe condo (loan balance is $390,000) 14,600 Interest on Prius automobile (personal use only) 2,400 American Express and Discover card interest (personal use only) 782 Total 37,082 Mike’s AGI was $94,500, and he files single. Calculate the amount of interest expense he can claim after any limitations. $__________
