Interest expenses can be a big part of your financial life, especially if you manage debt across personal, business or investment activities. However, not all interest is tax-deductible, and the deductibility depends on factors like how the loan proceeds are used and the type of interest. Here, Mike Crabtree, J.D., CPA, Partner, provides a simplified breakdown to help you determine the tax deductibility of interest expenses.
Types of Interest and Deductibility
Interest payments fall into different categories, each with its own tax rules. Here are the main types of interest and when they’re deductible:
- Personal Interest
- Deductibility: Not deductible.
- Interest on personal loans (like credit card debt) isn’t deductible. This applies to debt used for personal expenses.
- Investment Interest
- Deductibility: Deductible up to net investment income.
- Investment interest is the interest on debt used to buy assets for investment, such as stocks. You can deduct investment interest up to the taxable income your investments generate. If you pay more interest than your investment income, the excess can be carried forward to future years.
- Deductibility: Deductible up to net investment income.
- Residence Interest
- Deductibility: Generally deductible, with limits.
- Mortgage interest is deductible for loans up to $750,000 (or $1 million for loans before 2018 and after 2025), provided the funds were used to buy, build, or improve a primary home. For 2018 through 2025, home equity loan interest isn’t deductible unless used for home improvements, but this rule is set to change after 2025.
- Passive Activity Interest
- Deductibility: Deductible if passive income exceeds expenses.
- Interest on debt for business activities you don’t actively participate in is considered passive activity interest. This interest can only be deducted if your passive income exceeds passive expenses.
- Trade or Business Interest
- Deductibility: Fully deductible.
- Interest on debt used in your business is generally fully deductible. This includes loans or lines of credit tied directly to your business operations.
- Personal Interest
IRS Tracing Rules
The IRS tracing rules determine interest allocation based on how the loan proceeds are used. This means the tax deductibility of interest expense depends on the purpose of the loan, not the type of property securing it. To illustrate this, imagine you take out a loan secured by business property but use part of it for personal expenses – the interest is allocated between business and personal use. Following this example, if half of a loan is used for business equipment, interest on that half is deductible as a business interest. At the same time, the rest is non-deductible if spent on personal items.
Tips for Simplifying the Process
- Keep Loan Accounts Separate: To simplify interest allocation, use separate accounts for different types of debt. For instance, a loan used solely for business expenses should ideally come from a dedicated business account. Mixing personal and business funds makes interest deductions more complex, as IRS rules apply differently for mixed-use accounts.
- Margin Loan for Investment: For example, if you borrow on margin to buy securities, you pay investment interest. This interest is deductible up to your net investment income. If your investment income is less than the interest, the excess can be carried forward and deducted in future years when your investment income increases.
To maximize your deductible interest, make sure loan proceeds go toward deductible expenses. Mixing personal, business, or investment funds can complicate the allocation, and you may miss out on deductions.
Helping You Get There…
Keep your financial records organized, and set up separate accounts for personal, business and investment expenses. This way, it’s much easier to track and claim tax deductibility of interest expense accurately. Working with an experienced tax professional can also simplify the process, helping you navigate IRS rules and minimize your tax burden. Since interest deductibility depends on the loan type and how it’s used, understanding IRS tracing rules is essential. For specific advice on your unique situation, connect with Boulay’s tax team to help you make the most of your interest deductions.