34 / What are the general interest deduction rules?

As a general tax principle, interest is deductible by a cash basis taxpayer only to the extent the taxpayer actually pays it in cash or cash equivalent in the tax year.¹ Thus, if the interest due on a policy loan is not paid but is merely deducted [withdrawn] by the insurer from principal at the time of making the loan or merely added to loan principal, it is not currently deductible by a cash basis taxpayer.² Likewise, a cash basis taxpayer cannot deduct interest owing on a policy loan that is deducted by the insurer from the proceeds of a new loan with the balance being remitted to the policyholder.³ But if interest that has been deducted from or added to the principal amount of the policy loan is later paid, it is deductible by the cash basis taxpayer when paid.⁴ If the interest has been added to the loan principal, a deduction is allowable when, on maturity or surrender of the policy or on the death of the insured, the insurer deducts the accumulated interest from the proceeds.⁵

Cash basis taxpayers deduct prepaid interest over the period to which it relates, not in the year it is prepaid.⁶ An accrual basis taxpayer can deduct interest in the year it accrues, regardless of whether the interest is actually paid in that year.⁷

Only the person who owns a policy when the interest accrues is entitled to the deduction. A policy owner who takes out a policy loan and later makes an absolute assignment of the policy subject to the loan is not entitled to deduct interest that accrues after the assignment. For example, if a father continues to pay interest on policy loans after giving the policy to his children, he cannot deduct payments of interest accruing after the transfer.⁸ Nor can a husband deduct on a separate return the interest he pays on a policy loan when the policy is owned by his spouse.⁹ Similarly, a person to whom the policy has been assigned cannot pay and deduct interest that has accrued before the assignment.¹⁰