One common question taxpayers ask is whether the interest paid during the year is deductible on their income tax return. Unfortunately, the answer can be complex.
As you look to minimize your taxes, the possibility of tax-deductible interest payments is a consideration that should be evaluated by a professional. In the meantime, Boulay’s tax teamprovides a summary of the rules for tax-deductible interest.
Rules for Deducting Interest
Depending on the use of the original loan proceeds (for personal, investment or business activities), some interest payments may be tax deductible—but not all. The rules for deducting interest vary, based upon the category of the interest expense:
- Personal interest is not tax deductible.
- Investment interest (interest paid on debt that was used to acquire property held for investment) is limited to the taxpayer’s “net investment income.” If the interest paid exceeds the “net investment income,” the excess is carried forward to future tax years.
- Residence interest is generally deductible as an itemized deduction, but can potentially be subject to restrictions based on the rules in effect at the time the property was acquired.
- Passive interest (interest paid on debt used to acquire a business or income-producing activities in which you don’t “materially participate”), is generally deductible only if the income from the passive activities exceeds the related expenses.
- Trade or business interest (interest on debt that’s for activities in which you do materially participate), can generally be deducted in full.
Because of the of the different deduction limits imposed on the type of interest paid, the IRS provides rules to allocate interest expense among the categories. These “tracing rules” are based on the original use of the loan proceeds.
Tracing Rules
Under the tracing rules, interest expense is allocated in the same manner as stipulated by the underlying debt. This is done by tracing the original use of the debt proceeds to the specific type of expenditure.
The property securing the loan generally does not affect the way the interest is treated for tax purposes; rather, the use of the proceeds is the significant evaluation. The examples below illustrate.
Example 1: You take out a loan secured by property used in your business and use the proceeds in two ways. You use one portion of the loan proceeds in the business to acquire equipment, and the other portion to buy a new boat. You must allocate the interest expense between the business-use portion and the personal-use portion (the portion used to purchase the boat). This allocation must be done even though the loan is secured by business property. The interest on the portion that was used to acquire the new equipment is fully tax deductible as trade or business interest. Meanwhile, the interest paid on the portion that was used to acquire the new boat is personal interest and not tax deductible.
If a loan is secured by your home, you generally don’t have to allocate the loan proceeds or the interest. The interest on a mortgage loan of up to $750,000 ($1 million for tax years after 2025 and before 2018) is deductible if used to buy, build, or substantially improve your home.
The interest on a home equity loan of up to $100,000 is deductible for tax years before 2018, regardless of how the loan proceeds are used. Home equity interest deduction is disallowed for 2018-2025. Then, under current law, home equity loans will again be allowed as a tax deduction after 2025.
Overall, the IRS’s tracing rules are simple as long as you keep the loan proceeds separate.
Example 2: You borrow $200,000 on margin, and you use the full amount to buy securities. The interest you pay on the margin account is treated as investment interest and you can deduct the amount of interest paid, up to your net investment income.
Example 3: You borrow $150,000. Let’s assume that this debt is not secured by your home. The money is to be used in your consulting business. You deposit that $150,000 into a checking account that’s devoted entirely to your business, and you use the money in that account only for your business. The interest you pay on that line of credit is treated as trade or business interest.
The tracing rules become more complicated when funds from several different loans and non-loan amounts are co-mingled in a single account, from which expenditures are made for a variety of purposes. In this case, detailed ordering rules must be applied to match the debt with the associated expenditure.
Example 4: When borrowed funds from several loans are deposited into a single account at different times, the funds from the earliest loan are deemed to be used first. However, any expenditure you make within 30 days before or 30 days after you deposit loan proceeds in an account can be treated as being from those proceeds.
Ultimately, the best way to avoid the complications from co-mingling is to keep separate accounts for separate loans.
Helping you get there…
The requirements for tax-deductible interest payments and applying the tracing rules are very complicated. However, your interest payments can sometimes be leveraged to help minimize your taxes. Boulay’s tax team is here to assist you in evaluating your tax positions, to determine if your interest payments can be deducted. If you have questions on using the tracing rules to minimize your taxes, or wish to discuss these matters further, please connect with a member of Boulay’s tax team today.
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