If you’ve borrowed money from anyone other than a good friend or a family member, there’s a good chance you’re paying him or her interest. You may even be paying your friend or family member interest, depending on how long you’re borrowing for and how much they loaned you. That interest that you’re paying may or may not be deductible: a lot depends on what you’re using the money for. Let’s take a closer look at what makes the interest on the money you’ve borrowed eligible for a deduction.
There are several different types of interest that you can be charged. Some can be deducted and others can’t. The different types are:
- Personal Interest (credit cards, personal car loans, appliance purchases, etc.)
- Investment Interest
- Home mortgage interest
- Passive activity interest
- Trade or business interest
With reference to the categories listed above, the rules initially seem confusing. You cannot take a loan on money you buy for your personal items like your car or a dishwasher for your home, but you are able to deduct the interest on your home and your second home if you itemize – at least for the first million dollars worth of debt, whether it’s to buy the house(s) or improve them. You can also deduct $100,000 worth of equity debt on either or both of them combined, as long as they’re secured by the house itself. This provides something of a loophole for deducting interest on personal items, because you can use a home equity loan to buy something personal.
When it comes to interest that you’ve paid to buy investments such as stocks, mutual funds or land, you’re allowed to deduct the difference between the amount of investment income that you earned by the expenses, as long as they weren’t on non-taxable income. Again, the deduction is only available for taxpayers who choose to itemize their deductions, and if interest is paid on money borrowed to buy tax-free investments, it is not eligible for the tax deduction.
If you’re a business owner and your debt was incurred on an expense that was meant to produce income or operate your business, it is generally deductible. The rules indicate that you can’t “materially participate” in those activities, and that the money earned as a result of the expense being incurred is from passive activities such as real estate rentals. Still, the amount that you can deduct is only what is greater than the expenses incurred for the same activity, and there is a special allowance of up to $25,000 that begins to phase out once your adjusted gross income hits $100,000, and completely goes away once your AGI hits $150,000.
In direct contrast to passive interest, if you materially participate in activities related to the interest incurred on income-generating expenses, you can deduct them as a business expense in full.
Tracking which interest can be deducted and which isn’t can be complicated, especially because of all the limits and variables in some of the categories. To make things easier, the Internal Revenue Services has created what are known as “tracing rules” to allow taxpayers to track what loan proceeds are used for and whether they are deductible. The rules help to allocate debt into the different categories based on the disbursements of their proceeds to different expenses. Even though these rules were created with the best of intentions, they have created some unanticipated problems too. Examples of the types of situations that can lead to confusion include:
Say that a taxpayer borrows money to buy a car for his personal loan, as well as to refinance a loan on a rental property. He uses the property to secure the loan, and this creates a combination of a personal loan and passive interest loan. This means that he has to allocate the portion of the expense that is being used for the car, and the portion being used to refinance the property because only the latter portion is deductible.
Say that a taxpayer takes out a loan for $50,000 to use to finance his consulting business. He uses his home, on which there is no other equity debt, as security against the borrowed money, deposits the funds into his checking account, and only uses it for expenses for the business. This leaves him in a position where he has to deduct the interest as home equity deb interest instead of on his business, specifically because it falls below the $100,000 limit for home equity and because it is secured by his home.
Say that a taxpayer wants to buy a home for himself and he already owns a rental property, with no debt on that property. If he finances the home by borrowing against the rental property he will not be able to deduct the interest on the loan as rental property interest because he has to trace the use of the money to his home. He would have been able to deduct it if he had taken the loan as a home mortgage where the debt is secured by the home. The decision to borrow in the way described prevents him from deducting interest at all.
Interest deductions are tricky things, so you need to make sure that you plan carefully and are certain of all the possible outcomes before you take out a loan.