734 / Is interest deductible?
Editor’s Note: Late in 2015, Congress acted to extend the treatment of certain mortgage insurance premiums as qualified residence interest, as discussed below, through 2016. This treatment was extended through 2017 by the Bipartisan Budget Act of 2018, again through 2020 by the SECURE Act and through 2021 by CAA 2021 as of the date of this publication.
The deductibility of interest depends on its classification, as described below. Furthermore, interest expense that is deductible under the rules below may be subject to the additional limitation on itemized deductions (unless it is investment interest, which is not subject to that provision). Interest must be classified and is deductible within the following limitations:
(1) Investment interest. This includes any interest expense on indebtedness properly allocable to property held for investment.3 Generally, investment interest is deductible only to the extent of investment income; however, investment interest in excess of investment income may be carried over to succeeding tax years. For purposes of this calculation, net long-term capital gain income is included in investment income if the taxpayer foregoes the reduced tax rate (0 percent/15 percent/20 percent) that applies to such income. Under JGTRRA 2003, as extended by ATRA, certain dividends are taxable at the lower capital gains rates rather than at higher ordinary income tax rates. A dividend will be treated as investment income for purposes of determining the amount of deductible investment interest income only if the taxpayer elects to treat the dividend as not being eligible for the reduced rates.4 For the temporary regulations relating to an election that may be made by noncorporate taxpayers to treat qualified dividend income as investment income for purposes of calculating the deduction for investment interest, see Treasury Regulation Section 1.163(d)-1.5 Note that the 2017 tax reform legislation placed limitations on the deductibility of business interest, which specifically excludes investment interest.
(2) Trade or business interest. This includes any interest incurred in the conduct of a trade or business. Generally, such interest was deductible as a business expense prior to 2018. See Q for a discussion of the treatment of corporate business interest under the 2017 tax reform legislation. Q and Q outline the new rules as they apply to pass-through entities.6
(3) Qualified residence (mortgage) interest. Qualified residence interest is interest paid or accrued during the taxable year on debt that is secured by the taxpayer’s qualified residence and that is either (a) “acquisition indebtedness” (that is, debt incurred to acquire, construct or substantially improve the qualified residence, or any refinancing of such debt), or (b) “home equity indebtedness” (any other indebtedness secured by the qualified residence). There is a limitation of $1,000,000 ($750,000 for 2018-2025) on the aggregate amount of debt that may be treated as acquisition indebtedness, but the amount of refinanced debt that may be treated as acquisition indebtedness is limited to the amount of debt being refinanced. Prior to 2018, a deduction was generally allowed for home equity indebtedness. The aggregate amount that could be treated as “home equity indebtedness” (that is, borrowing against the fair market value of the home less the acquisition indebtedness, or refinancing to borrow against the “equity” in the home) was $100,000.7 Indebtedness incurred on or before October 13, 1987 (and limited refinancing of it) that is secured by a qualified residence is considered acquisition indebtedness. This pre-October 14, 1987 indebtedness is not subject to the $750,000 (2018-2025) aggregate limit, but is included in the aggregate limit as it applies to indebtedness incurred after October 13, 1987.8 (For 2007 through 2021, certain mortgage insurance premiums are treated as qualified residence interest.)9
Planning Point: Although interest on home equity indebtedness is technically no longer deductible under the terms of the 2017 tax reform legislation, the IRS has released guidance on situations where this interest may continue to be deducted. Pursuant to the guidance, interest on home equity loans that are used to buy, build or substantially improve the taxpayer’s home continue to be deductible to the extent that they (when combined with other relevant loans) do not exceed the $750,000 limit. However, home equity loan interest is not deductible to the extent that the loan proceeds are used for expenditures not related to buying, building or substantially improving a home (i.e., if the proceeds are used for personal living expenses or to purchase a new car, the related interest is not deductible). The home equity loan must be secured by the home in order for the interest to be deductible in any case.
A “qualified residence” is the taxpayer’s principal residence and one other residence that the taxpayer (a) used during the year for personal purposes more than fourteen days or, if greater, more than 10 percent of the number of days it was rented at a fair rental value, or (b) used as a residence but did not rent during the year.10
Subject to the above limitations, qualified residence interest is deductible. If indebtedness used to purchase a residence is secured by property other than the residence, the interest incurred on it is not residential interest but is personal interest.11 The Tax Court denied a deduction for mortgage interest to individuals renting a home under a lease with an option to purchase the property. Although the house was their principal residence, they did not have legal or equitable title to the home and the earnest money did not provide ownership status.12 An individual member of a homeowner’s association was denied a deduction for interest paid by the association on a common building because the member was not the party primarily responsible for repaying the loan and the member’s principal residence was not the specific security for the loan.13 Assuming that the loan was otherwise a bona fide debt, a taxpayer could deduct interest paid on a mortgage loan from his qualified plan, even though the amount by which the loan exceeded the $50,000 limit of IRC Section 72(p) was deemed to be a taxable distribution.14 See Q for a more detailed discussion of how the mortgage interest deduction was changed by the 2017 tax reform legislation.
(4) Interest taken into account in computing income or loss from a passive activity. A passive activity is generally an activity that involves the conduct of a trade or business but in which the taxpayer does not materially participate, or any rental activity.15
(5) Interest on extended payments of estate tax. Generally, this interest is deductible.
(6) Interest on education loans. An above-the-line deduction is available to certain taxpayers for interest paid on a “qualified education loan.”16 The deduction is subject to a limitation of $2,500 in 2015-2024. The deduction is phased out for 2015-2018, ratably for taxpayers with modified AGI between $65,000 and $80,000 ($135,000 and $165,000 (joint returns) in 2017-2018).17 Certain other requirements must be met for the deduction to be available.18 In 2019-2021, the phaseout range is $70,000 and $85,000 for single filers and $140,000 and $170,000 for joint returns.19 In 2022, the phaseout range is $70,000 and $85,000 for single filers and $145,000 and $175,000 for joint returns.20 In 2023, the phaseout range is $75,000 and $90,000 for single filers and $155,000 and $185,000 for joint returns.21 In 2024, the phaseout range is $80,000 and $95,000 for single filers and $165,000 and $195,000 for joint returns.22 In 2025, the phaseout range is $85,000 to $100,000 for single filers and $170,000 to $200,000 for joint returns.23
(7) Personal interest. This is any interest expense not described in (1) through (6) above and is often referred to as “consumer” interest.24 Personal interest includes interest on indebtedness properly allocable to the purchase of consumer items and interest on tax deficiencies. Personal interest is not deductible.25
The proper allocation of interest generally depends on the use to which the loan proceeds are put, except in the case of qualified residence interest (excluding home equity interest, where the use is relevant for 2018-2025). Detailed rules for classifying interest by tracing the use of loan proceeds are contained in temporary regulations.26 The interest allocation rules apply to interest expense that would otherwise be deductible.27
Various provisions in the Code may prohibit or delay the deduction of certain types of interest expense. For example, no deduction is allowed for interest paid on a loan used to buy or carry tax-exempt securities or, under certain conditions, for interest on a loan used to purchase or carry a life insurance or annuity contract (see Q 3).
1. IRC § 163(h)(3)(F).
2. IRC § 163(h)(3)(F)(ii).
3. IRC § 163(d)(3).
4. IRC §§ 1(h)(11)(D)(i), as amended by ATRA, 163(d)(4)(B).
5. 69 Fed. Reg. 47364 (8-5-2004). See also 70 Fed. Reg. 13100 (3-18-2005).
6. IRC § 162.
7. IRC § 163(h)(3).
8. IRC § 163(h)(3)(D).
9. IRC § 163(h)(3)(E), as amended by ATRA.
10. IRC § 163(h)(4)(A). See, e.g., FSA 200137033.
11. Let. Ruls. 8743063 and 8742025.
12. Blanche v. Commissioner, TC Memo 2001-63, aff’d without opinion, 2002 U.S. App. LEXIS 6379 (5th Cir. 2002).
13. Let. Rul 200029018.
14. FSA 200047022.
15. IRC §§ 163(d), 469(c).
16. IRC §§ 163(h)(2)(F), 221.
17. IRC § 221(b); Rev. Proc. 2016-55, Rev. Proc. 2017-58.
18. IRC § 221; Treas. Reg. § 1.221-1.
19 Rev. Proc. 2018-57, Rev. Proc. 2019-44, Rev. Proc. 2020-45.
20 Rev. Proc. 2021-45.
21 Rev. Proc. 2022-38.
22 Rev. Proc. 2023-34.
23. Rev. Proc. 2024-40.
24. IRC § 163(h)(2).
25. IRC § 163(h)(1).
26. Temp. Treas. Reg. § 1.163-8T.
27. Temp. Treas. Reg. § 1.163-8T(m)(2).