Is Interest Tax Deductible?
Debt and taxes – they’re both burdensome and can be terribly difficult to fully understand. Thankfully, there’s good news; some of the interest you’ve been paying each month may actually reduce the amount of taxable income at the end of the year.
Each year, the IRS allows taxpayers to claim certain expenses as deductions from their total income to identify their ‘taxable’ income, or the percentage of earnings that is subject to state and federal tax. Deductions (also called tax breaks or itemized deductions) lower the amount of your total income that is eligible for taxation.
Years ago, you could claim any form of interest as a deduction – even credit card interest on charges like extravagant family vacations or designer clothes. Eventually, Congress buckled down and made adjustments to tax laws, stating that only certain types of interest were tax deductible. These changes have made debt management a more pressing issue than ever before; consumers no longer receive tax breaks for interest in certain categories, like credit card purchases or personal loans.
Here’s a comprehensive summary of the different types of interest and their impact on your taxable income each year.
Personal interest is categorized as any interest paid on goods or services that aren’t used exclusively for work or business related purposes. Interest accrued on credit card purchases like home computers, meals, personal vehicles, or clothes is considered personal interest, and is not tax deductible. Generally speaking, when you make monthly payments to your credit card that include interest, it is nondeductible. This same logic applies even if you use your credit card during the purchase of your home.
Interest from vehicle loans, retail or appliance loans, and peer-to-peer loans is categorized as personal interest and is never tax deductible.
The Evolution of Personal Interest Deductions
As mentioned earlier, there was a time when all forms of interest were tax deductible. Credit card interest and other forms of personal interest were deductible on income taxes until Congress passed the Tax Reform Act of 1986, shutting the door on several tax breaks for consumers.
According to records from the Treasury Department, allowing personal interest deductions was a way to encourage American consumers to spend their money rather than investing it. In reality, these personal interest deductions were actually reducing tax revenues; people wrote off large amounts of credit card debt, thus lowering their taxable income, instead of putting that money into savings, which would earn them interest and was eligible for government taxation.
Deductible Credit Card Interest
If credit cards are used to purchase work or business related items, that interest is no longer categorized as personal interest. Most companies – regardless of size – use credit cards to buy equipment and supplies or fund daily transactions. The interest on these charges are tax deductible, as they have become a cost of doing business.
These deductions, in turn, lower the amount of business earnings that are subject to tax. Be careful; if you are using one credit card for both business and personal purposes, you need to exercise extreme caution when itemizing deductions.
How You Can Avoid Nondeductible Credit Card Interest
Look for alternative ways to fund your purchases to avoid accruing nondeductible credit card interest. An example for students: instead of using a personal credit card to pay for school supplies and tuition, consider securing a student loan. The IRS allows you to deduct interest payments that are made on this type of loan until it is paid off.
Additionally, utilizing a home equity loan (instead of a credit card) may help provide the funds you need to make personal purchases and also allow you to claim the interest as a tax deduction.
On the Topic of Home-Equity Loan Interest
All interest from a home-equity loan is considered eligible as a tax deduction up to $100,000 – regardless of how the funds are used. The deductible amount is reduced to $50,000 if you submit taxes as ‘married filing separately’. There is, of course, another layer to this; interest from home-equity loans is deductible for alternative minimum tax (AMT) purposes only if you use the proceeds to purchase, build or enhance a primary or secondary residence.
Summary: If you are using AMT, be aware that you may not get any tax break if you borrow $50,000 against the equity in your home to buy a new truck and jet off to Maui for a week. On the other hand, if you spend that same amount of money to install a beautiful, terraced barbecue pit and gazebo in your backyard, you can safely deduct the interest under both AMT and regular tax rules.
Home-equity loan interest tax breaks aren’t the only perk to being a homeowner; you are also allowed an itemized deduction for interest up to the first $1 million of mortgage debt on eligible homes, as long as it was used to purchase or enhance a primary personal residence or one additional home. This amount drops to $500,000 if you complete your taxes under the ‘married filing separately’ status. Third homes (and beyond) that are used as personal residences are considered nondeductible personal expenses, and do not qualify for any tax breaks.
In order to get the biggest tax break out of your home(s), make sure you stay under $1 million in mortgage debt and pay cash for your third residence. Click here for the comprehensive IRS manual for home mortgage interest deductions.
Which Properties Qualify?
The IRS states that a home can be a house, mobile home, boat, condominium, apartment, or recreational vehicle so long as it has sleeping, cooking, and toilet facilities.
What About my Vacation Home?
The mortgage interest paid on vacation homes is deductible, so long as it is a second property and falls under the limits listed earlier. A warning to investment property owners: if you rent the home out at least part-time, the tax rules become more complex.
Vacation homes that fall into the ‘qualified residence’ category include beach homes, mountain cabins, trailer homes, etc so long as the proceeds from the loan were used to acquire the actual residence. In order to receive the qualified residence interest tax deduction, your home mortgage debt must not exceed $1,000,000 plus $100,000 of home equity debt. In total, all interest on debt secured against an eligible residence cannot exceed the value of that residence for a tax deduction, and must adhere to the $1,000,000 and $100,000 limits.
Who Gets the Deduction?
If you are the primary borrower, you do! So long as you are obligated to pay the debt (documents in your name) and you are actually making payments. If you co-signed for the loan with a spouse, you are both considered primary borrowers. If you are making payments on a family member’s mortgage and are not listed as a co-signer, you cannot claim that interest as a deduction.
What if I Refinance?
If you refinance a mortgage that is considered an acquisition debt, the new balance is also treated as an acquisition debt (up to the balance of the original mortgage). The excess amount is treated as home-equity debt, and any interest on the first $100,000 of that excess amount becomes deductible. You may also deduct the points you pay to get the new loan over the life of the loan, as long as the new balance qualifies as home acquisition debt or home-equity debt (under the $100,000 limit).
With that being said, you could theoretically deduct 1/30th of the points every year over the body of a 30 year mortgage – $33 a year for each $1,000 of points spent. You get to deduct all the remaining points in the year that you pay off the loan (whether through a sale or another refinance), unless you refinance through the same lender. In that scenario, borrowers add the points paid on the latest deal to the leftovers from the original refinancing and deduct the pro-rated expenses over the life of the new loan.
Tax Deductions for Investment Interest
In most cases, you can deduct interest paid on money you borrowed to invest. When you borrow funds and use the loan to buy investment assets, the interest is referred to as investment-interest expense.
These types of investments include rental properties, stocks, or anything that you expect to produce taxable income in a given year. When you file taxes, you cannot claim more in investment interest than you actually earned in investment income. You can, however, carry any “disallowed” investment interest over to the next year.
For interest on loans used to purchase nontaxable investment tools, like bonds or muni-bonds, you may not claim a tax deduction. The IRS doesn’t allow taxpayers to claim interest on debts that are used to generate income without being subject to taxation. A clever investor would maximize write-offs by spending borrowed funds on taxable investments and using cash to secure the nontaxable ones.
Is Student Loan Interest Tax Deductible?
Thankfully, you can deduct up to $2,500 of paid student loan interest in a single tax year. Like with other tax rules, there is an income contingency: your adjusted gross income cannot exceed $80,000 if you want to take advantage of this deduction.
For an in-depth explanation of Student Loan Interest tax exemptions, click here.