Five types of interest expense, three sets of new rules

Interest is the amount paid for use of borrowed funds.The tax treatment of interest a taxpayer pays or accrues depends on the type of interest. In the context of individual income tax, most interest can be classified as one of five types:

• Qualified student loan interest;
• Qualified residence interest;
• Investment interest;
• Business interest; and
• Personal (consumer) interest.

Qualified student loan interest and business interest are deductible before adjusted gross income (AGI, above the line), qualified residence interest and investment interest are deductible from AGI (below the line), and personal interest is not deductible.

There are timing issues on when to deduct qualified residence interest, investment interest, and business interest. Discussions and examples in this article will refer to "2017" and "2018 and after" because beginning in 2018, the old rules are suspended for eight years (2018 through 2025).¹ In theory, and as the Internal Revenue Code now reads, the 2017 rules will be restored in 2026.

Interest is classified by the way loan proceeds are used.² For instance, if loan proceeds are used to buy investment property or business property, the interest paid is classified as investment interest or business interest.

Qualified student loan interest

Up to $2,500 of interest on qualified student loans is deductible before AGI.³ To be a qualified student loan, a loan must meet the following requirements:⁴

• It must be used for qualified education expenses, i.e., tuition, room, board, books, equipment, and other necessary expenses, such as transportation, and these expenses must be paid within a reasonable time before or after the taxpayer takes out the loan;
• It must be used for the qualified education expenses of the taxpayer, his or her spouse, or someone who is the taxpayer's dependent when the loan was taken out; and
• The student must be enrolled at least half-time in a program leading to a degree, including a graduate degree, or other recognized educational credential at an accredited college, university, vocational school, or other post-secondary educational institution that is eligible to participate in a U.S. Department of Education student aid program.

In calculating the student loan interest deduction, qualified education expenses must be reduced by, among other things:⁵

• Nontaxable employer-provided educational assistance benefits;
• Tax-free scholarships; and
• Veterans' educational assistance benefits.

In 2018, the deduction is phased out if modified adjusted gross income (MAGI)⁶ is between:⁷

• $65,000 and $80,000 (for all taxpayers except married filing jointly), or
• $135,000 and $165,000 (for married taxpayers filing jointly).

The deduction for interest on a qualified student loan is not available for someone who (1) is claimed as another's dependent,⁸ or (2) is married and files using the filing status of married filing separately.⁹

Example 1: G, a single taxpayer, paid $3,000 of interest on a qualified student loan. G has adjusted gross income (AGI) of $70,000. G can deduct interest of $1,667, calculated as follows: $2,500 maximum amount of student loan interest - $833 phaseout = $1,667 deductible student loan interest.

The $833 amount of the phaseout is calculated as $2,500 (maximum amount of student loan interest) × [$5,000 (amount AGI exceeds lower end of range) ÷ $15,000 (range of income for phaseout)].

Qualified residence interest

Home mortgage interest on a qualified residence¹⁰ is deductible from AGI as an itemized deduction. There are two types of qualified residence interest — acquisition indebtedness interest and home-equity indebtedness interest.¹¹ Acquisition indebtedness refers to debt that (1) is incurred to acquire, construct, or substantially improve a qualified residence, and (2) is secured by that qualified residence.¹² Home-equity indebtedness is (1) any debt that is not acquisition indebtedness, and (2) secured by a qualified residence.¹³

The law known as the Tax Cuts and Jobs Act¹⁴ changed the rules regarding the deduction of qualified residence interest, decreasing the amount of acquisition interest that is deductible and suspending the deduction for home-equity indebtedness.¹⁵ As a result of these changes, two sets of rules apply for qualified residence interest, one for years before 2018 and earlier years and one for 2018 through 2025.

Qualified residence interest, years before 2018

In years before 2018, interest is deductible on acquisition indebtedness up to $1,000,000 for single taxpayers, heads of household, and married taxpayers filing jointly and $500,000 for married taxpayers who file separately.¹⁶ Interest on home-equity indebtedness is deductible to the extent the debt does not exceed the lesser of:

• The fair market value (FMV) of the residence, reduced by acquisition indebtedness, or
• $100,000 ($50,000 for married taxpayers who file separately).¹⁷

The total amount of acquisition indebtedness and home-equity indebtedness, the interest on which is deductible, cannot exceed $1,100,000 ($1,000,000 + $100,000). As the IRS ruled in Rev. Rul. 2010-25, a single mortgage loan that is secured by a qualified residence can be both acquisition indebtedness and home-equity indebtedness.

Example 2: Many years ago, a married couple took out a mortgage to acquire their residence. In November 2017, when their home is worth $600,000 and their first mortgage is $250,000, they take out a second mortgage of $110,000 to buy a pleasure boat.

On their joint return, they can deduct:

• All of the interest on the $250,000 first mortgage because the first mortgage is acquisition indebtedness; and
• The interest paid on $100,000 of the second mortgage of $110,000 because the second mortgage is home-equity indebtedness.

Qualified residence interest, years 2018 through 2025

For 2018 through 2025, interest is deductible on acquisition indebtedness up to $750,000 ($375,000 for married taxpayers filing separate returns).¹⁸ However, the lower limitation does not apply to acquisition indebtedness incurred on or before Dec. 15, 2017. A taxpayer who enters into a written binding contract before Dec. 15, 2017, to close on the purchase of a principal residence before Jan. 1, 2018, and who purchases that residence before April 1, 2018, is treated as having incurred the acquisition indebtedness on the residence on or before Dec. 15, 2017.

The separate deduction for home-equity indebtedness interest is suspended in the years 2018 through 2025.¹⁹ Nonetheless, if a home-equity loan is used to buy, build, or substantially improve the taxpayer's main home or second home that secures the loan and the loan is less than the cost of the home, the interest on that loan will be deductible as acquisition indebtedness (subject to the $750,000/$375,000 acquisition indebtedness limits).

Example 3: Assume the same facts as Example 2, except the home-equity debt of $110,000 is incurred in 2018 or after.

On their joint return, the married couple can deduct:

• All of the interest on the $250,000 first mortgage because the first mortgage is acquisition debt, and
• None of the interest on the second mortgage ($110,000) because it is used to buy a boat. However, if it had been used to buy, build, or substantially improve their current residence, it would all be deductible because their acquisition indebtedness does not exceed $750,000.²⁰

Example 4: In 2018 or after, a married couple buy a principal residence with acquisition debt of $800,000. Of the interest paid, they can deduct 93.75% ($750,000 ÷ $800,000).

Refinancing existing home mortgage

The $1,000,000 limitation continues to apply to taxpayers who refinance existing mortgage debt that was incurred before Dec. 15, 2017, so long as the debt resulting from the refinancing does not exceed the amount of the refinanced debt.²¹

Points

Lenders sometimes charge points in addition to the stated interest rate. Each point represents 1% of the loan. On a $280,000 loan, one point is $2,800 ($280,000 × 1%), two points is $5,600 ($280,000 × 2%), etc.

Points are treated as a service fee or prepaid interest, depending on what they cover. If points cover services (e.g., appraisal, document preparation, notary services, and recording services), the points are a nondeductible service fee. If points represent the borrower's buying down the interest rate, the points are prepaid interest. For every point the borrower pays, the interest rate is reduced about 0.25%.

In general, points that represent prepaid interest are deductible over the term of the loan.²² However, if those points are paid in connection with the purchase of a principal residence, and if certain conditions²³ are satisfied, points are deductible as qualified residence interest in the year paid.

Example 5: In 2018, to acquire a residence, B takes out a 30-year $300,000 mortgage, and pays two points or $6,000 ($300,000 × 2%).

If points are for the lender's services, $6,000 is a nondeductible service fee.

If the loan is to purchase a second residence, and the points represent prepaid interest, the $6,000 paid for the points is deductible over 30 years (term of the loan) on a straight-line basis.

If the loan is to purchase a principal residence, the points represent prepaid interest, and the conditions of Sec. 462(g) are satisfied, the full $6,000 paid for the points is deductible as qualified residence interest in 2018.

Mortgage insurance

If a borrower makes a down payment of less than 20% of the appraised value or selling price, the lender often requires the borrower to get mortgage insurance. Mortgage insurance protects the lender in case the borrower defaults.

The annual mortgage insurance fee varies from around 0.3% to 1.15% of the original loan amount, depending on the size of the down payment and the loan. For years before 2018, mortgage insurance premiums are considered to be qualified residence interest.²⁴

The deduction for mortgage insurance premiums is phased out by 10% for every $1,000 ($500 for married filing separately), or part thereof, of AGI over $100,000 ($50,000 for married filing separately).²⁵

The deduction for mortgage insurance premiums is completely phased out if AGI exceeds $110,000 ($55,000 for married filing separately).

Example 6: To acquire a principal residence for $450,000, B makes a 10% down payment of $45,000 and takes out a mortgage of $405,000 ($450,000 - $45,000). B pays an annual mortgage insurance premium of $2,430 ($405,000 × 0.6%).

If B's AGI is less than $100,000, B can deduct $2,430 as qualified residence interest.

If B's AGI is $106,000, he can deduct $972 as qualified residence interest, calculated as follows: $2,430 mortgage insurance premium - $1,458 phaseout ($2,430 × 60%) = $972 qualified residence interest. The 60% is calculated by taking the $6,000 that B's AGI exceeds the $100,000 threshold, dividing by 1,000 to figure the number of thousands (6) and multiplying by 10% per thousand (60%).

Investment interest

Investment interest is any interest that is paid or accrued on debt allocable to property held for investment.²⁶ Thus, if a taxpayer borrows money to buy investments (e.g., stocks and bonds), the interest on the loan is investment interest. Investment interest is deductible from AGI as an itemized deduction to the extent of net investment income,²⁷ which is calculated as follows: Gross investment income - Investment expenses = Net investment income.

Investment income is the gross income from property held for investment, excluding net capital gains from the disposition of property held for investment and qualified dividend income (QDI). It includes, among other things, interest, dividends (other than qualified dividends), annuities, and royalties derived from investments, not from a trade or business. If taxpayers want to increase their investment interest deduction, they can elect to include some or all of their QDI or net capital gain in gross investment income.²⁸ In this case, however, taxpayers must reduce, by the same amount, their adjusted net capital gain (i.e., QDI and net capital gain) that would be eligible for lower capital gain tax rates.

Investment expenses include deductible expenses, other than interest expense, that are directly connected to the production of investment income.²⁹ They include investment fees, custodial fees, and other expenses for managing investments that produce taxable income.³⁰

In 2017, investment expenses included in calculating the investment interest deduction limit are those allowed after application of the 2% floor on miscellaneous itemized deductions.³¹ In calculating the amount of investment expenses that exceed the 2% floor, expenses that are not investment expenses are disallowed before any investment expenses are disallowed. In 2018 through 2025, because miscellaneous itemized deductions are not deductible, no investment expenses are deductible and therefore no investment expenses are deducted in calculating the investment interest deduction limit.³²

Investment interest in excess of net investment income is carried forward and treated as investment interest paid or accrued in the next year.³³

Interest paid or accrued to produce tax-exempt income

In general, expenses incurred to produce tax-exempt income are not deductible. Under Sec. 265(a)(2), taxpayers cannot deduct interest that is paid or accrued on obligations that produce tax-exempt interest. For instance, taxpayers cannot deduct interest on loans used to acquire state and local government bonds.

Example 7: In 2017, H has (1) gross investment income of $7,000; (2) investment expenses, other than interest, of $5,000; (3) investment interest of $5,000; and (4) AGI of $60,000. There are no other miscellaneous itemized deductions, other than the $5,000 mentioned in (2).

With regard to investment interest of $5,000:

• $3,200 ($7,000 gross investment income - $3,800 deductible investment expenses) is deductible in 2017.The $3,800 in deductible investment expenses is calculated by subtracting $1,200 ($60,000 AGI × 2%) from the $5,000 in investment expenses other than interest.
• $1,800 ($5,000 - $3,200) is carried forward and treated as investment interest in 2018.

  Example 8: Assume the same facts as Example 7, except now H does not want to carry forward a deduction of $1,800 and has QDI of $1,750.

H can elect to treat QDI as gross investment income. In this case, with regard to investment interest of $5,000:

• $4,950 ($8,750 gross investment income - $3,800 deductible investment expenses) is deductible in 2017; and
• $50 ($5,000 - $4,950) is carried forward and treated as investment interest in 2018.

By using QDI ($1,750) this way (adding it to the $7,000 in investment interest), a deduction for investment interest expense is increased by $1,750, from $3,200 to $4,950, but the amount eligible for capital gains preferential tax rates is reduced by $1,750.

Example 9: Assume the same facts as Example 7, except now it is 2018, not 2017.

With regard to investment interest of $5,000:

• The full $5,000 is deductible in 2018 because the net investment income limit is $7,000 ($7,000 in investment income less $0 of investment expenses). As noted above, because miscellaneous itemized deductions are not deductible in 2018, no investment expenses are deductible.
• There is no excess of investment interest over net investment income to be carried forward to 2019.

Business interest

Taxpayers can deduct business interest, which is interest paid or accrued on indebtedness properly allocable to a trade or business (other than the trade or business of performing services as an employee).

Example 10: A sole proprietor borrowed money three times: to purchase a storefront, to purchase inventory, and to meet payroll between busy seasons. Since the proceeds of these loans are used to purchase business assets or pay business expenses, they are allocable to a trade or business. The interest on these loans is therefore business interest, deductible before AGI.

For business interest paid in years after 2017, the deduction of business interest is limited. A business can deduct its business interest only to the extent of its business interest income, plus 30% of business adjusted taxable income, plus the business's floor plan financing income.³⁴ Business interest expense exceeding the limitation amount can be carried forward indefinitely.³⁵ While the limitation applies to all business entity forms, there are special rules for applying the limitation and the carryforward of excess business interest for partnerships and their partners and S corporations and their shareholders.³⁶

The limitation does not apply to small taxpayers, which are defined as taxpayers with average annual gross receipts of $25 million or less for the three-year period ending with the prior tax year.³⁷ In addition, taxpayers in certain trades or businesses are excepted or can elect to be excepted from "trades or businesses" for purposes of the limitation. Taxpayers in the trade or business of performing services as an employee and certain regulated public utilities are excepted.

Taxpayers that can elect out of being considered a trade or business include real property trades or businesses³⁸ and certain farming businesses.³⁹ Farming businesses that make the election must use the alternative depreciation system (ADS) to depreciate any property used with a recovery period of 10 years or more.

Adjusted taxable income means taxable income, disregarding:⁴⁰

• Any item of income, gain, deduction, or loss that is not properly allocable to a trade or business;
• Any business interest or business interest income;
• The amount of any Sec. 172 net-operating-loss (NOL) deduction;
• The amount of any Sec. 199A deduction; and
• In the case of tax years beginning before Jan. 1, 2022, any deduction allowable for depreciation, amortization, or depletion.

Adjusted taxable income also takes into account any other adjustments as provided by the IRS.

Example 11: In 2018, a taxpayer has business interest income of $20 million, business interest expense of $100 million, and no floor plan financing interest. The taxpayer has net business interest expense of $80 million ($20 million - $100 million). Assume that none of the exceptions apply, so the taxpayer is subject to the limitation on the deduction for business interest.

As the table "Calculation of Business Interest Deduction" (below) reveals, the taxpayer has:

• Taxable income of $140 million;
• Adjusted taxable income of $250 million; and
• Deductible business interest expense of $100 million.

Example 12: Assume the same facts as in Example 11, except now the taxpayer is a real property trade or business. If the taxpayer uses the ADS to depreciate the real property used in its trade or business, the taxpayer can elect out of the business interest limitation. If the taxpayer makes the election, the taxpayer can deduct business interest of $100 million, not $95 million, in 2018.

Example 13: Assume the same facts as in Example 11, except now the taxpayer is an automobile dealer. The taxpayer's business interest expense of $100 million relates to financing its inventory, the vehicles in the showroom and on the parking lot. Accordingly, none of its interest is subject to limitation, and the taxpayer can deduct business interest of $100 million in 2018.

Personal (consumer) interest

Personal interest, also called "consumer interest," is not deductible.⁴¹

Consumer interest is any interest that is not qualified student loan interest, qualified residence interest, investment interest, business interest, or passive activity interest, and interest on unpaid estate tax for the period of an extension under Sec. 6163. Consumer interest includes the following:

• Interest on car loans (unless the taxpayer uses the car for business);
• Interest on federal, state, or local income tax; and
• Finance charges on credit cards and revolving charge accounts, the balances of which are incurred for personal expenses.

Example 14: For the year, a taxpayer paid the following interest:

• $2,500 on a loan to purchase a camper for recreational purposes.
• $250 on a Macy's credit card, used to purchase clothing for family members.
• $100 on a Visa credit card, used to purchase food (groceries and restaurant meals) for family members.

Since none of this interest falls under any of the exceptions to consumer interest, the interest is not deductible.

Allocation of interest

If taxpayers use debt proceeds for more than one purpose (e.g., business and personal), they must allocate interest on the debt to each purpose.⁴² Taxpayers allocate interest in the same way as the debt proceeds are allocated.

Example 15: On Nov. 1, a taxpayer borrows $80,000 and puts it in one checking account. At the end of each month, the taxpayer pays interest of $800.

The taxpayer falls within the $25,000,000 gross-receipts exception, so the taxpayer is not subject to the 30% business interest expense limitation.

The taxpayer uses the loan proceeds as follows.

• On Nov. 1, $20,000 for a personal-use car; and
• On Dec. 1, $60,000 for business equipment.

The taxpayer pays interest of $1,600 in November and December, of which:

• $1,000 is consumer interest and not deductible; and
• $600 is business interest and deductible before AGI.

All $800 of the November interest is personal interest, since at that time no part of the loan has been used for business purposes. In December, the interest must be allocated between personal and business interest — 25% is personal ($20,000 ÷ $80,000) and 75% is business ($60,000 ÷ $80,000). Thus, $200 ($800 × 25%) is personal interest in December and $600 ($800 × 75%) is business interest.

2017, 2018, and beyond

Taxpayers and their advisers need to understand the new rules covering the deductibility of business interest, investment interest, and personal residence interest. In addition, tax professionals need to be aware that these rules are currently set to sunset after 2025 but may be extended beyond that date.

Because of the increase in the standard deduction and changes to itemized deductions (e.g., the limit on deductibility of local taxes and elimination of certain itemized deductions), many taxpayers who previously itemized will no longer do so. In the past, many taxpayers were advised that debt related to their residence (acquisition indebtedness and home-equity indebtedness) was better than other types of personal debt because of the income tax benefits from the deductibility of interest related to home mortgages.Moving forward, many of these taxpayers will no longer itemize, making it likely that the interest rate will be the only consideration when making these choices in the future. However, if the rules do sunset after 2025, debt related to a taxpayer's residence will regain its importance.  

Footnotes

¹Due to the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97.

²Temp. Regs. Sec. 1.163-8T(c).

³Secs. 221(a) and (b).

⁴Sec. 221(d)(1).

⁵Sec. 221(e)(1).

⁶Sec. 221(b)(2)(C).

⁷Secs. 221(b)(2)(A) and (B). These MAGI limits are inflation-adjusted (Sec. 221(f)).

⁸Sec. 221(c).

⁹Sec. 221(e)(2).

¹⁰A qualified residence includes a taxpayer's principal residence and one other residence that the taxpayer uses as a residence (Sec. 163(h)(4)(A)(i)).

¹¹Sec. 163(h)(3)(A).

¹²Sec. 163(h)(3)(B).

¹³Sec. 163(h)(3)(C).

¹⁴P.L. 115-97.

¹⁵A taxpayer is considered to have incurred acquisition debt prior to Dec. 15, 2017, provided (1) the taxpayer entered into a binding written contract before Dec. 15, 2017, (2) to close on the purchase of a principal residence before Jan. 1, 2018, and (3) who purchases such residence before April 1, 2018 (new Sec. 163(h)(6)(F)(IV)).

¹⁶Sec. 163(h)(3)(B).

¹⁷Sec. 163(h)(3)(C).

¹⁸Sec. 163(h)(3)(F)(i)(II).

¹⁹Sec. 163(h)(3)(F)(i)(I).

²⁰IRS news release, IR-2018-32.

²¹Sec. 163(h)(3)(F)(iii)(I).

²²Sec. 461(g).

²³See Sec. 461(g)(2).

²⁴Sec. 163(h)(3)(E)(i). This provision expired at the end of 2017, after being retroactively reinstated by the Bipartisan Budget Act of 2018, P.L. 115-123.

²⁵Sec. 163(h)(3)(E)(ii).

²⁶Sec. 163(d)(3)(A).

²⁷Sec. 163(d)(4)(A).

²⁸Sec. 163(d)(4)(B).

²⁹Sec. 163(d)(4)(C).

³⁰IRS Publication 529, Miscellaneous Deductions, p. 9 (2016).

³¹Sec. 67(a).

³²Sec. 67(g).

³³Sec. 163(d)(2).

³⁴Sec. 163(j)(1). Floor plan financing interest is interest on floor plan financing indebtedness, which is indebtedness used to finance the acquisition of motor vehicles, boats, or farm machinery for sale or lease and secured by the inventory acquired with the proceeds of the indebtedness (Sec. 163(j)(9)).

³⁵Sec. 163(j)(2).

³⁶See Sec. 163(j)(4).

³⁷Sec. 163(j)(3).

³⁸As defined in Sec. 469(c)(7)(C).

³⁹Sec. 163(j)(7)(A)(iii).

⁴⁰Sec. 163(j)(8).

⁴¹Sec. 163(h)(1).

⁴²Temp. Regs. Sec. 1.163-8T(c)(1).