Interest rates have gone up over the last few years. Saving grace: You may be able to deduct interest expenses depending on the type of expense incurred. Notably, there are four main categories for tax purposes.
Mortgage interest: Generally, you can deduct mortgage interest paid during the year. To qualify, you must be legally obligated to pay the mortgage and the loan must be secured by a qualified residence (i.e., your principal residence or one other home). Then you have to determine if the debt is an acquisition debt or a home equity debt.
- Acquisition debt: This is a debt incurred to buy, build or substantially improve a qualified home. Under the Tax Cuts and Jobs Act (TCJA), only the interest paid on up to the first $750,000 million of acquisition debt is deductible, down from $1 million. (However, certain prior debts are “grandfathered” so the higher limit may still apply.)
- Home equity debt: Other debts (e.g., a home equity loan or line of credit) are generally treated as home equity debt. Previously, the interest paid on up to $100,000 of home equity debt was deductible, but the TCJA suspends this write-off for 2018 through 2025.
Note that a home equity debt may be converted into an acquisition debt if the loan proceeds are used for substantial home improvements like adding an in-ground pool or finishing a basement.
Investment interest: If you borrow funds to buy property held for investment purposes (e.g., securities or real estate), the interest paid on the loan is treated as investment interest. The amount of investment interest you can deduct is generally limited to the amount of your “net investment income” for the year. Any excess is carried over to the next year.
Net investment income includes gross income from property held for investment such as interest, annuities and royalties. But it does not include capital gains and qualified dividends eligible for tax-favored treatment. The maximum tax rate for long-term capital gain and qualified dividends is generally 15% (20% for some high-income taxpayers) in contrast to ordinary income taxed at rates up to 37%. Note: You can elect to include long-term capital gain and qualified dividends as net investment income if you are willing to forfeit the preferential tax rate.
Business interest: The interest incurred by your business may be fully deductible. However, under the TCJA, the annual deduction for business interest is currently capped at 30% of adjusted taxable income (ATI). Key exception: A small business with average gross receipts of $25 million or less for the past three years (indexed to $29 million in 2023) is exempt from the limit.
Personal interest: If an interest expense does not fall into one of the other three categories, it is generally treated as nondeductible personal interest. This includes most credit card debt. Key exception: You may be able to deduct student loan interest paid for qualified higher education expenses— like tuition, room and board and books and fees—if the loan is in your name. This maximum deduction of $2,500 is phased out for high-income taxpayers.
This is only a brief summary of a complex set of rules. Obtain professional tax advice for your situation.
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