Curious about how the interest paid on borrowed money? For example, if you borrow money will the interest you pay be deductible for income tax purposes? The deductibility of loaned money is complicated. And unfortunately, not all the interest an individual pays is tax-deductible. The rules for deducting interest vary, and depend on what the loan is used for. Examples include personal items, investment, home mortgage, business activities or higher-education.
Interest expense for borrowed money can fall into any of the following categories:
Personal interest
Personal interest is not deductible. Typically, this includes interest paid on personal credit card debt, personal car loans, home appliance purchases, etc.
Investment interest
Investment interest is typically paid on debt incurred to purchase investments such as land, stocks, mutual funds, and the like. However, interest on debt to acquire or carry investments that produce tax-free income is not deductible at all. The annual investment interest deduction is limited to “net investment income”. This is the total taxable investment income reduced by tax-deductible investment expenses.
Prior to the tax reform enacted in 2017, these expenses often included investment advisory fees. (Advisory fees that were part of miscellaneous itemized deductions.) However, for years 2018 through 2025, the deduction of these types of expenses is suspended.
Currently, the IRS’s instructions to Form 4952, list only depreciation and depletion as examples of eligible expenses. Most individuals typically won’t have these expenses. So, for most taxpayers, their investment interest deduction will be limited to the amount of their investment income. However, the investment interest deduction is only allowed to taxpayers who itemize their deductions on Schedule A.
Home mortgage interest
Home mortgage interest includes the interest on a taxpayer’s primary home and a single second home. However, the debt on which the interest is deductible is generally limited to $750,000 of home acquisition debt. Home acquisition debt being debt used to purchase or substantially improve the home(s). The acquisition 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.
Interest paid on equity debt, is not deductible as home mortgage interest with a couple of exceptions. (Equity debt is debt that may result when acquisition debt is refinanced.)
The exceptions for equity debt include:
- When the loan proceeds are used to make substantial improvements to the home, the debt is treated as acquisition debt. Interest on that debt would be deductible.
- If the amount of a new loan just replaces the balance of the old acquisition debt, the interest would continue to be deductible as home mortgage interest. (That is, as long as the $750,000 or $1 million debt cap isn’t exceeded.)
But if the new loan is greater than the balance of the old acquisition loan and isn’t used for substantial home improvements, the interest on the excess debt is not deductible.
Note: the rules stated here are for federal tax purposes; state rules may be different.
Borrowed money for a passive activity interest
Passive activity interest includes interest on debt that’s for business or income-producing activities where the taxpayer doesn’t “materially participate”. This debt 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
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. Although the deduction is limited for taxpayers with average annual gross income for the prior three years exceeding $27 million. The details of this limitation are not covered in this article. However additional information can be found on the IRS website.
Borrowed money for educational loans
Interest paid on a qualified student loan may be claimed as an above-the-line deduction (i.e., itemizing isn’t required). The maximum deduction per year is $2,500. This is a per return limit, not a per student limit. Mixed-use loans don’t qualify. A “qualified student loan” is one used to pay college expenses, like tuition, room and board, and related expenses. It is specifically earmarked for attending post-secondary educational institutions, or vocational schools, and postgraduate training, on behalf of the taxpayer, spouse, or any dependent of the taxpayer. For 2022, the deduction is phased out at higher income levels. And the deduction is not allowed when filing using the married separate status, or if the taxpayer is a dependent of someone else. Once the AGI reaches the upper amount, no deduction is allowed for that year.
Interest Deduction Tracing Rules For Borrowed Money
Because of the variety of limits imposed on interest deductions, the IRS provides special rules. These “tracing rules”, allocate interest expense among the categories. Also the rules are generally based on the use of the loan proceeds. Interest expense follows what the loan proceeds were used for. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures, i.e., by “following 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:
Borrowed Money Example 1
A taxpayer takes out a loan secured by her rental property. She 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 loan is secured by the business property, the personal loan interest portion is not deductible.
Example 2
A taxpayer takes out a loan secured by his rental property and uses the proceeds to finance a European vacation. The use of the funds was to pay for a vacation and thus the interest on the loan is nondeductible. This is because the funds were a personal interest expense.
Example 3
The taxpayer owns a rental property free and clear. He wants to purchase a home that he’ll use as his personal residence. 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, the debt must be secured by the home, for the interest to be deductible, which it is not. Result: the interest is not deductible anywhere.
Example 4
The taxpayer uses her bank credit card to pay her son’s college tuition and related expenses. In addition, she pays for his clothing, food, household items, vacations, etc. None of the interest she pays on the credit card balance can be allocated to education interest. This is because interest paid on mixed-use debt is not allowed for the student loan interest deduction.
However, if she had one credit card that she used solely for her son’s eligible education expenses, the interest would be deductible as student loan interest. At least it would if she didn’t exceed the modified AGI phaseout limit.
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 consider calling the office for assistance in applying the various interest limitations and tracing rules. This will ensure you don’t inadvertently get some unexpected results.
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