Not All Interest Is Deductible For Taxes

Article Highlights:

• Interest Categories 
• Category Deductibility 
• 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 the loan proceeds are used for personal, investment, or business activities. 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 – this is typically 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,” which is the total taxable investment income reduced by investment expenses (other than expenses related to investments that produce non-taxable income). The investment interest deduction is only allowed to taxpayers who itemize their deductions. 
  
  
• Home mortgage interest – includes the interest on a taxpayer’s primary home and a single second home. However, the debt for which the interest is deductible is generally limited to $1 million of home acquisition debt (debt used to purchase or substantially improve the home(s)) and $100,000 of equity debt between the first and second homes. Both the acquisition debt and the equity debt must be secured by the home(s) to be deductible as home mortgage interest. In addition, home mortgage interest is only deductible by those who itemize their deductions. Tax Tip: Equity debt can be used to purchase personal use items, and thereby a tax deduction for the interest paid on that loan is allowed. 
  
  
• Passive activity interest – includes interest on debt that's for business or income-producing activities in which the taxpayer doesn’t “materially participate” and is generally deductible only if income from passive activities exceeds expenses from those activities. The most common passive activities are probably real estate rentals. For 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 – 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. 

Because of the variety of limits imposed on interest deductions, the IRS provides special rules to allocate interest expense among the categories. These “tracing rules,” as they are called, are generally based on the use of the loan proceeds. Thus interest expense on a debt is allocated in the same manner as the allocation of the debt to which the interest expense relates. Debt is allocated 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:


As you can see, it is very important to plan your financing moves carefully, especially when equity in one asset is being used to acquire another. Please call this office for assistance in applying the various interest limitations and tracing rules to ensure you don’t inadvertently get some unexpected results.

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