Interest Expense

Only home mortgage interest and investment interest are deductible on Schedule A. Student loan interest may be deducted on Page 1 of the 1040. Business interest is reported on Schedule C. Both home mortgage and investment interest are subject to several restrictions.

Home Mortgage Interest

In order for home mortgage interest to be deductible there are 3 conditions that must be met.
  • You must file Form 1040 and itemize your deductions
  • You must be legally liable for the debt
  • The mortgage must be a secured debt on a qualified home.

A qualified home means your main (primary) home or second home. You cannot deduct interest on more than two personal residences. A home may include a single-family house, a duplex, a condo, a cooperative, or a houseboat. You should receive a Form 1098 from your mortgage lender listing the amount of interest paid each year.

Home mortgage interest is classified as grandfathered, acquisition, or as home equity. Different rules apply for deducting each type.

Grandfathered interest applies to mortgages that you took out on or before October 13, 1987. Interest on these mortgages is fully deductible

Acquisition interest is interest on debt incurred in order after October 13, 1987 to buy, build, or improve your home. This interest is fully deductible if the amount of acquisition debt plus grandfathered debt is $1,000,000 or less ($500,000 if married filing separately).

Home equity debt is debt incurred after October 13, 1987 other than to buy, build, or improve your home. The interest is fully deductible on these mortgages if the amount of home equity debt is $100,000 or less ($50,000 if married filing separately).

If your debt exceeds these limitations, then the interest is only partially deductible.

Points

Points are charges paid by a borrower to obtain a home mortgage. They are sometimes called loan origination fees, maximum loan charges, or loan discount. You are considered to pay points even if the seller actually pays them.

Points may be fully deductible in the year paid, or they may be deducted over the life of the loan. In order to be deductible in the year paid, the following criteria must be met:
  • Your loan is secured by your principal residence, or main home.
  • Paying points is a normal business practice in your area.
  • The points are the normal amount charged for loans in your area.
  • The points were not paid instead of other amounts that are ordinarily included on the closing statement, such as appraisal and inspection fees.
  • You use the loan to buy or build your main home.
  • The points were stated as a percent of the loan amount.
  • The amount is clearly shown on the closing statement as points.
  • The funds you provided at or before closing plus points paid by the seller were at least as much as the points charged.
  • You are a cash basis taxpayer. This means that you report income in the year received and deduct expenses in the year in which they are paid.

If the loan is a home improvement loan, and you meet the above criteria, the points may be deducted in the year paid.

If the loan is to refinance your present home, or for a second home, the points must be deducted over the life of the loan. In other words, if you have a 20-year loan, and the points are $2,000 you can deduct $100 per year as interest expense on Schedule A.

If the loan is paid off early, you may deduct any points not already deducted in the year in which the loan is paid off.

Investment Interest

If you borrow money to buy property you hold for investment purposes, the interest you pay is investment interest. Property can be stocks, bonds, land, or other income producing property not a part of the ordinary course of your business. Investment interest can be deducted only to the extent you have investment income. If you include qualified dividends and capital gains as investment income, these items will not be eligible for the favorable capital gains rate.

Any investment income that is disallowed may be carried forward to future years. When the investment is sold any interest expense not previously deducted may be added to the cost basis of the asset.

You calculate your investment interest deduction on Form 4952.

Student Loan Interest

Qualified student loan interest may be deducted on Line 33 of page 1 of the 1040 (or Line 18 of 1040A). You do not have to itemize your deductions to deduct student loan interest. A qualified student loan is one that you took out solely to pay qualified education expenses for you, your spouse, or a dependent. These expenses must have been paid or incurred within a reasonable time of taking out the loan. Loans from relatives and you employer are not considered qualified student loans.

Qualified education expenses for this purpose are limited to tuition and fees, room and board, books and supplies, equipment, and other necessary expenses.

This deduction is limited to $2,500 and the student must have been enrolled at least half-time in a degree program.

Other Interest Issues

Personal interest is not deductible. This includes items such as interest on car loans; interest paid on federal, state, or local taxes; or finance charges on credit cards. If these items are related to your business, they may be deductible on Schedule C.

Interest paid on rental or royalty property may be deductible on Schedule E. Interest on a business farm may be deducted on Schedule F.

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