Take Advantage of Tax Rules To Decrease Your Debt Service Expense

Debt can sure come in handy when buying a major asset like a house or car or managing unexpected expenses. Thankfully, the interest you pay on this debt can often provide a helpful deduction on your tax return. However, the IRS is very specific regarding the situations where interest is or is not deductible. The rules can be quite complex, so a discussion with your tax professional is always a good idea. Here are several typical examples of how the IRS treats interest payments.

Note: This article appeared in Parsec’s Q4 newsletter on debt management. Read the full newsletter.

Mortgage interest:
If you pay interest on a loan that is secured by property (particularly for a home you own), you can deduct the interest you pay on that mortgage, subject to the limits below. This is typically reported to you on a Form 1098 from the lender, which includes not only the interest you paid during the year but also an identification of the property that secures the loan.

Here are the most typical limits on this deduction:

  • For a couple filing a joint tax return, the maximum residential debt for which you could deduct interest is $750,000, if you incurred the debt after Dec. 15, 2017. If your debt was incurred before then, the limit is $1 million. To calculate the amount, you must include debt on both your primary home and any secondary home(s).
  • As of 2018, interest paid on a home equity line of credit (HELOC) is no longer deductible, even if the debt was incurred in an earlier year, unless the HELOC proceeds were used to acquire or make a major improvement on the home.

Interestingly, you can deduct mortgage interest secured by a boat or recreational vehicle if it has cooking, sleeping and toilet facilities.

Investment interest:
Often, investors will set up a margin account with a brokerage firm to trade securities or take out a loan to invest in a partnership or other business. The IRS considers this investment interest, and the interest is deductible only to the extent of investment income. Investment income does not normally include qualified dividends or capital gains, but a special election can be made on a tax return to include these as investment income for this purpose. If your tax return includes a Form 4952 with a large amount of unused investment interest, you may want to consider this election. Any interest paid on a loan to buy tax-exempt securities, however, is never deductible.

Student loan interest:
Parents can take a beneficial above-the-line deduction for interest paid on student loans if their children were dependents when the loans were issued. However, the deduction is limited to $2,500 and phases out for couples with a combined income over $140,000.

Business interest:
Interest paid on debt incurred for a business or rental operation is fully deductible, although if the rental activity generates a loss, then passive loss rules could apply.

Personal interest:
This sad category includes a number of situations for which the IRS allows no deduction at all, including credit card interest, loans secured by an automobile, interest paid to the IRS or state tax authorities in the form of a penalty, and finance charges on personal expenditures.

Interest expense deductions can take some of the sting out of debt payments, but you may need some help navigating complex IRS rules. We are happy to guide you!

Brad Burlingham, CPA
Director of Tax Services


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