5 Categories of Interest Expense: What's Deductible?

People often ask: Is the interest paid during the year deductible on my federal income tax return? The answer is, "It depends." Generally, the interest you incurred must be allocated among the following five "baskets" for tax purposes. Based on how the interest is classified, it may be nondeductible, partially deductible or fully deductible. Other special limits also may apply.

1. Mortgage Interest

Mortgage interest is usually the biggest interest deduction available on a personal return if you itemize. To qualify for this tax break, the mortgage must be secured by your principal residence or one other home, such as a vacation home. Plus, you must be legally obligated to pay the mortgage.

However, there are new rules for 2018 through 2025 imposed by the Tax Cuts and Jobs Act (TCJA) that apply to the two main types of qualified mortgage interest:

• ‍Acquisition debt. This is debt incurred to buy, build or substantially improve a qualified residence. Under the TCJA, interest paid on up to $750,000 of acquisition debt is deductible, down from $1 million under pre-TCJA rules. But there's a key exception: The prior $1 million limit continues to apply to loans made before December 16, 2017.‍
• Home equity debt. Other mortgage debt — including home equity loans and lines of credit — is treated as a home equity debt. Prior to the TCJA, the interest paid on up to $100,000 of home equity debt was deductible, but this write-off has been suspended through 2025.

Important: A home equity loan may be converted into acquisition debt if the proceeds are used to make substantial home improvements. Otherwise, no deduction is currently allowed for this type of interest expense.

2. Investment Interest

When you borrow money for investment purposes — say, to buy stock on margin — you generally can deduct the interest you pay as investment interest. But this deduction can only be claimed by people who itemize, and it's limited to the amount of your annual "net investment income." Any excess is carried over to the next year. The definition of net investment income includes gross income from property typically held for investment purposes, such as interest income, annuities and royalties.

Important: Net investment income doesn't include tax-favored long-term capital gains and qualified dividends. But you can elect to count these toward the investment interest deduction on your tax return if you forfeit the preferential tax treatment. The maximum tax rate on long-term capital gains and qualified dividends is 15% (or 20% for high-income taxpayers). This isn't an all-or-nothing proposition. You can cherry-pick the long-term capital gains and qualified dividends covered by the election.

Other special rules apply to "passive activity" interest. If an activity is characterized as a passive activity that you don't actively participate in, current deductions are limited to income generated by passive activities. Real estate is automatically treated as a passive activity, but a limited write-off may be available.

3. Student Loan Interest

If you qualify, you can deduct up to $2,500 of the annual interest paid on student loans, subject to a phase-out based on modified adjusted gross income (MAGI). The deduction is claimed "above the line," so it's available regardless of whether you itemize. To be eligible for this deduction, you must be legally obligated to repay the loan. Therefore, parents can't claim the deduction for a child who's liable for the payments.

In addition, the loan must be a legitimate arrangement to borrow money to pay for qualified education expenses, such as:

• Tuition,
• Room and board,
• Books, supplies and equipment,
• Transportation, or
• Other fees.

On 2021 returns, the phase-out occurs between $70,000 and $85,000 of MAGI for single people (between $140,000 and $170,000 for married people who file joint returns). This threshold will remain the same in 2022.

4. Business Interest

Under pre-TCJA tax law, interest incurred for business reasons was fully deductible, without any restraints. But things have changed.

First, the TCJA limited the deduction for net interest to 30% of the employer's adjusted taxable income (ATI) for the year, beginning in 2018. Then the CARES Act increased the applicable ATI limit to 50%, but only for 2019 and 2020. The 30%-of-ATI limit is back in play for 2021 and thereafter, absent any other legislation.

Net interest is defined as the amount of interest paid or accrued during the year less the amount of interest income included in your taxable income for the year. ATI is your business income without regard to the following:

• Income, deduction, gain or loss not properly allocable to a business,
• Business interest income and expense,
• Net operating losses (NOLs),
• The qualified business income (QBI) deduction, and
• Any deduction allowable for depreciation, amortization or depletion (for tax years beginning before 2022).

Important: There's an important exception to the limitation on business interest expense deductions: A small business with average gross receipts of $25 million or less for the last three years is exempt from the 30%-of-AGI limit. This threshold is adjusted annually for inflation. For tax years beginning in 2021, the inflation-adjusted limit is $26 million. For 2022, it's $27 million.

5. Personal Interest

If interest expense isn't included in one of the other baskets, it's generally treated as nondeductible personal interest. This includes loans taken out to purchase nonbusiness vehicles and credit card charges incurred to buy items of a personal nature, such as a TV, jewelry or a vacation. It also includes interest paid on nonbusiness loans between family members, but if those loans qualify as student debt, they may be deductible under certain circumstances (see above).

Usually, the nature of an interest expense is clear, depending on the use of the proceeds. But if borrowed funds are commingled with other money in a bank account, the funds must be divided among the different baskets based on complex IRS rules. To avoid any hassles, keep loan proceeds in separate accounts with each one designated for a specific purpose.

For More Information

With so many categories of interest expense, it's sometimes hard to keep track of the current tax rules. If you have any further questions regarding the tax treatment of interest expenses, contact your professional tax advisor.