The Internal Revenue Service (IRS) allows you to deduct several different types of interest expense, including home mortgage interest and interest related to the production of income. But, it does not allow deductions for consumer interest expense.
While the basics are easy to understand, truly determining if your interest expense is deductible is not always so simple. To help with the specifics, here’s a quick guide to interest expense.
Mortgage interest deduction
When is mortgage interest deductible? If you took out a mortgage to buy the house you live in, the interest on that mortgage is generally deductible. If you refinance, it’s likely deductible. It’s also still deductible if you took out a home equity line of credit (HELOC).
You can deduct the interest on the mortgage for your second home the same way. A “second home” may be a beach house, cabin, mobile home, house trailer, boat or similar property. As long as it has sleeping, cooking and toilet facilities, it’s a second home.
When is it not deductible? The IRS limits mortgage interest deductions in some cases. If you have a very expensive home, you may not be able to deduct the full amount. You can deduct interest on up to a $1,000,000 mortgage balance ($500,000 if you are married filing separately).
Additionally, there are limits on the mortgage interest deduction for home equity debt or other loans you take out after you own the property. You can only deduct your interest on a home equity loan balance of up to $100,000 ($50,000 if married filing separately). If you refinance your home for more than the initial balance, and the money isn’t used to buy, build, or improve your home, you must treat the excess amount as home equity debt.
If you have more than two homes, you can’t deduct interest on more than your primary home and one other. However, if you rent out the other homes full- or part-time, you can likely take a rental expense deduction.
Home office expense
When is mortgage interest deductible as a home office expense? If you have a business or work from home, you can include part of your home mortgage interest as a home office expense as long as you qualify.
However, you must then reduce your mortgage interest on Schedule A. You can’t take a double deduction of the same interest.
When is it not deductible? If you use the Simplified Method for computing your home office deduction, you deduct $5 for every square foot of qualified business use, up to 300 square feet. In that case, you can’t also deduct your mortgage interest as a business deduction. However, you can still deduct your full mortgage interest expense on Schedule A.
Investment interest expense
When is investment interest expense deductible? When you borrow money to make an investment, you can generally deduct the interest expense on that loan.
When is it not deductible? Your net investment income limits your investment interest expense deduction in any year. If you paid more investment interest than you received in net investment income, you can carry forward the excess amount to another year.
It’s best to keep loans for personal and investment use separate. If you borrow money for personal reasons and investment use, you must allocate the debt between the two.
Investment interest expenses, along with other miscellaneous itemized deductions, are subject to a “floor” before you can deduct them. That means there is a minimum amount you have to incur before you get the benefit of the deduction. Therefore, your total miscellaneous itemized deductions, including investment interest expense, is only deductible to the extent it exceeds 2 percent of your adjusted gross income.
When is it deductible? Interest expense related to your business or rental is deductible. There is no “floor,” as with investment interest expense. It is not limited to the amount of net income you have from the business. The loan can be a secured or unsecured loan as well as a business credit card.
When is it not deductible? You can’t deduct interest on overdue taxes, or on money borrowed to pay taxes. If you borrow money from relatives, you must carefully document the loan and the purpose of the loan to avoid extra scrutiny from the IRS.