Paying interest is a reality that most of us deal with, whether we like it or not. Be it your student loans or home mortgage, there are a number of common debts that accrue interest. The longer interest accrues, the more expensive repayment becomes—and when you’re dealing with tens or hundreds of thousands of dollars of debt, interest can quickly add up.
Even if you’re fortunate enough to have low interest rates, it’s only natural to seek ways to reduce your overall outgoing costs. Believe it or not, tax season may be the ultimate break to catch when it comes to paying interest. Now comes the golden question: is interest on debt tax-deductible? The answer is sometimes—using this guide, we’ll walk you through the types of interest that are tax-deductible, the benefits of deducting interest, and provide answers to relevant commonly asked questions.
- What Types of Interest are Eligible for Deduction?
- What is the Benefit of Deducting Paid Interest?
- Tax-Deductible Interest FAQs
What Types of Interest are Eligible for Deduction?
Before the imposition of the Tax Reform Act of 1986, taxpayers were allowed to deduct interest on a sprawling array of debts, including credit card debt and personal loans. This mid-1980s tax reform law effectively ousted deductions for personal interest, thereby making credit card, personal loan, and medical loan interest exempt from deduction on tax returns.
Though the tax laws regarding interest haven’t changed much over the course of the past few decades, there are a number of tax-deductible interest types that are designed to reduce your annual taxable income. Interest paid on student loans, mortgages, business loans, and margin debts are among the most common. Let’s take a more in-depth look at how each of these types of interest can affect your tax filing and what forms you’ll need to deduct them.
Student Loan Interest
As of 2020, there are an estimated 44.7 million borrowers with student loan debt—most of which will likely be able to deduct accrued interest on their tax returns. This number continues to amass with every passing year, and to accommodate the ever-increasing number of university students burdened with weighty debts, the IRS grants a student loan interest deduction.
The student loan interest deduction allows you to deduct a maximum of $2,500 from your taxable income so long as your modified gross income (MAGI) was less than $70,000 in the past tax year. The loan(s) in question must qualify under IRS standards to be eligible for tax-deductibility.
Qualified loans must be taken out by either you, the taxpayer, a spouse, or a dependent. Qualified loans also must have been taken out for educational purposes during a time in which you, your spouse, or dependent is enrolled at least part-time in a degree program. Additionally, the loan in question must have been used to pay for tuition, textbooks, coursework supplies, fees, or other relevant expenses.
Qualification for the student loan interest deduction is also contingent upon the educational institution’s eligibility. Under IRS mandate, eligible institutions include all public, non-profit, and privately-owned-for-profit post-secondary institutions that participate in student aid policies managed by the US Department of Education.
If you paid more than $600 in interest in 2019, you will automatically receive Form 1098-E in the mail or via email. If you paid less than $600, you can still deduct paid interest—you will need to contact your student loan provider and request a physical or digital copy of Form 1098-E.
Business Loan Interest
Growing and operating a business requires a number of expenses that are often funded by business loans. From accommodating lines of credit to property mortgages, there are a number of uses for everyday business loans.
Like any other loan, business loans accrue interest over time. Fortunately, this interest is tax-deductible under certain conditions. These conditions include a true lender-debtor relationship, legal liability for the debt, and an agreement from both lender and debtor for the debt to be repaid. The type of loan you have will also impact how much of your interest is tax-deductible.
The following are among the most common types of business loans that may be eligible for small business deductions:
- Term Loans
- Business Lines of Credit
- Short-Term Loans
- Personal Loans (for mixed purposes)
- Business Purchase Loans
To calculate the amount of business interest you can deduct for the tax year, use IRS Form 8990. With these narrowed down numbers, sole proprietors and single-member LLCs should claim deductible interest in the “Expenses” section of Schedule C on Line 16. For partnerships and multiple-member LLCs, these expenses should be recorded in the “Other Deductions” section of Form 1065.
Do note that you will be required to provide proof of the business debt in the event that you’re audited by the IRS, should you claim a deduction for interest paid. Keep in mind that businesses with average gross receipts of $25 million or more can only deduct up to 30% of interest on their business debts before taxes, depreciation, amortization, interest.
Margin Debt Interest
If you borrow money from a lender for investment, you may be able to claim a deduction for interest on margin debt incurred. The value of the deduction is capped at the net taxable investment income you’re able to claim during the tax year—in the event that you do not have any net taxable investment income to claim, you can carry over the remaining interest expense. This grants you the ability to potentially deduct the interest from net taxable investment income the following tax-filing year.
The deduction for margin debt interest is calculated using IRS Form 4952, but can also be done with some quick math. To calculate your deductible margin interest, take your gross income and subtract all qualified deductions, net gains, and other investment expenses—the remaining number is your net investment income. For example, if you have an investment income of $1,000 and interest expenses of $500, you can deduct all $500 on your tax return.
Home Mortgage Interest
If you borrow money to afford a home, you may be eligible to qualify for a mortgage interest deduction. Per IRS regulations, you can take up to $750,000 in an interest deduction if you purchased your home after Dec. 15, 2017. This also applies to mortgages up to $1 million purchased prior to Dec. 15, 2017.
You can also take advantage of the home mortgage interest deduction if you pay home equity loan debt, but only under the condition that you use the proceeds from the home equity loan to build, buy, or improve the home that secures the home equity loan.
To claim the home mortgage interest deduction, you’ll need IRS Form 1098, or your mortgage interest statement, from your mortgage lender, well-kept records documenting the details of your home and mortgage, and Schedule A to claim your itemized deductions. Be sure to read through IRS Publication 936 to gain more detailed insight into what types of documentation the IRS will want to see to verify and approve your deduction.
What is the Benefit of Deducting Paid Interest?
The crowning benefit of deducting paid interest is gaining the ability to reduce your taxable income. Like all other types of tax deductions, taking advantage of interest deductions could allow you to move down into a lower tax bracket. This would allow you to be taxed at a lower federal rate, effectively putting more money back into your pockets.
Tax-Deductible Interest FAQs
● Are personal loans tax deductible?
Interest paid on personal loans, such as a car loan or a furniture loan, is not tax-deductible. Similarly, interest paid on credit card debt is also generally not tax-deductible. The exception is if the personal loan was used to afford business expenses and you have proper documentation to support your case to the IRS. Keep in mind that to deduct the interest on a personal business loan, you must be the person legally responsible for the loan and you must be able to itemize the exact portion of interest paid that is attributable to your qualified business expenses.
● Do I need to itemize my deductions to take advantage of tax-deductible interest?
To claim any deduction for interest paid on any debts, you will need to itemize deductions on your tax return. It’s worth noting that because the standard deduction was almost doubled beginning under the 2018 Tax Cuts and Jobs Act, taking the standard deduction rewards most taxpayers a higher return than claimed itemized deductions. If you’re unsure of what move is best for you, reach out to one of our tax preparation experts for some sage advice.