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Interest expense of an individual (deductible and nondeductible) must be classified into the following categories:
Interest expense is allocated among the various categories based on the use to which the proceeds are put. Of the five classifications of interest only qualified residence interest and investment interest is deductible as itemized deductions. Business interest, meaning interest incurred in carrying on a trade or business in which you materially participate, is fully deductible on the related business schedule. Passive activity interest, meaning interest incurred in a passive activity, is combined with other passive activity expenses and deductible to the extent of passive income. Personal interest, meaning interest falling outside of the other four categories, is nondeductible except for certain student loan interest as discussed earlier.
Interest is only deductible in any event by an individual who is liable for the underlying debt. Where two or more individuals are jointly liable for a debt, each taxpayer is entitled to a deduction for the interest that he or she actually pays, subject to the statutory limitations, even if he or she pays more than a proportionate share of the debt.
Tracing rules apply to interest. You must be able to trace the use of the funds to the activity you are deducting the interest for. A check directly written from the account or a charge receipt provides the accepted evidence. If you pass the money through several accounts before you pay it out, the government will make a case that the funds comingled with other funds and will disallow the deduction as personal interest.
If the funds in the account are comingled with other types of loans there may be a problem deducting the interest. Generally, if a definite prorata share can be established a percentage of the interest is deductible. But this is only true if the funds were directly paid out of the account by check or charge receipt. The only exception to the tracing rules is in the case of home equity interest, which is deductible regardless of the use of the funds as long as it is within the limitations of $100,000 in principle described below.
Qualified Residence Interest
Qualified residence interest on a principal residence or on a combination of a principal home and a designated second home is fully deductible. To be considered qualified residence interest the debt must be secured by a qualified residence and the debt cannot exceed certain dollar limitations. The definition of a qualified residence is very broad. The Temporary Regulations indicate that so long as the facility has basic living accommodations such as sleeping space and toilet and cooking facilities, it will fall within the definition of a qualified residence.
The law divides interest on a qualified residence into two different classifications:
Acquisition debt is fully deductible as long as the acquisition debt on a residence does not exceed the home's value and total acquisition debt does not exceed $1 million ($500,000 for married filing separately).
Tax Trap: During the life of the ownership of your home, your allowed acquisition debt is limited to the original amount of your loan, plus any loans for improvements to the property, less the amortization of the loan over time. If the amount of your allowed acquisition debt drops to below the fair market value of the residence and you refinance your home, any amount over the allowed acquisition debt becomes home equity debt. If the home equity debt exceeds $100,000 the interest on the amount of the excess of home equity debt over $100,000 is non-deductable personal interest.
Home equity debt is any other debt secured by a qualified residence that does not exceed the home's value. Total home equity debt can not exceed $100,000. If the debt is in excess of $100,000, the deductibility of the interest is limited.
Pointer: Consider equity lines of credit or second mortgages to pay personal expenses so that the interest may be deductible. But do not overextend yourself and risk losing your home.
A portion of mortgage interest after refinancing is subject to the AMT. Basically, if a mortgage is refinanced for the same amount, (payoff to new mortgage), then there is no problem and no AMT allocation. If additional funds are borrowed (even if the funds are to pay the settlement costs), then there is an allocation. The taxpayer is responsible to monitor this situation. It's even worse if a home-equity line pays off an original mortgage. As the line is reduced and if subsequent borrowing are made, the subsequent borrowing (not for home improvement) will be subject to the AMT. Attached is Rev Rul 2005-11 which addresses refinanced mortgage interest and the AMT. Our thanks to Charlie Slade for pointing this out.
Points are charges made by a lending institution when loans are made and are generally expressed as a percentage of a loan amount. When points are paid for the use of money they will receive the same tax treatment as interest payments. Therefore, points paid on a loan to purchase a principal residence are fully deductible in the year paid so long as the mortgage debt does not exceed $1 million. Points paid on a second home are claimed ratably over the term of the loan so long as the debt does not exceed $1 million. This proration of interest is called amortization. Unamoritized points on a second mortgage or loan refinance are deductible at the time the loan is paid off, even if this is due to another second mortgage or refinance which is paid off at settlement. These represent sunk costs. Points paid when a mortgage is refinanced are amortized over the term of the new loan. If the loan proceeds included additional debt to improve the home, that portion of the points is fully deductible in the year paid.
Business Interest is interest which is used to purchase business assets or pay for business expenses. Business Interest is deducted on the business form for the business that the money was spent for. Usually, if you pay personally for a corporate business expense it cannot be deducted on your personal taxes but must be reimbursed by the corporation to be deducted. See S Corporation section below for more information on this entity. Sole proprietorship and partnership interest on business expenses would be deducted on the related business form Schedule C or Form 1065, since the entity is not a separate legal entity in these cases. With limited partnerships, limited partners do not materially participate and they must get reimbursed by the partnership for the amount to be deducted by the partnership. Interest on these amounts are generally not deductible.
Investment interest is any interest incurred to purchase property that is held for investment, such as raw land, or property that produces interest, dividends, or annuities. Investment interest is deductible as an itemized deduction to the extent of the investment income. Any nondeductible investment interest is carried forward and deducted in a succeeding year if there is sufficient investment income. Gains on the disposition of income producing investment assets under ususal rules would give rise to additional investment income. However, under the capital gains rules, if the taxpayer elects to use the reduced capital gains rates, then the gain is not considered investment income for calculating deductible investment income.
Pointer: Interest paid by a S Corporation shareholder or partner on borrowed funds loans or contributed to the entity is generally characterized as business interest when the owner materially participates in the business. The interest is deductible on the related business schedule. For a flow through entity, the deduction would be taken on Schedule E.
Interest paid on late or overdue taxes is considered non-deductible personal interest expense. The Appeals Courts have upheld IRS regulations that prohibit a deduction.
Personal interest is very important because the interest rates are usually higher than other types of interest, and since personal interest is not deductable the after tax rate on the interest is more than what you would expect by looking at the APR. For example if you are in a 28% federal bracket and an 8% state bracket this is a 36% effective tax bracket. If you pay 20% interest on a loan which is not deductable that is the same as paying 27.2% interest that is deductable.
Effective Loan planning can eliminate this interest and save you lots of money. Click here to find out more about loan planning which can save you thousands of dollars in excess interest.