Interest Tracing Rules
If you borrow money will the interest you pay be deductible for income tax purposes? The answer to that question can be complicated, and unfortunately, not all the interest an individual pays is tax-deductible. The rules for deducting interest vary, and essentially depend on what the loan proceeds are used for: personal items, investment, home mortgage, business activities or higher-education. Interest expense can fall into any of the following categories:
Personal interest – is not deductible. Typically, this includes interest paid on personal credit card debt, personal car loans, home appliance purchases, etc.
Investment interest – this is typically paid on debt incurred to purchase investments such as land, stocks, mutual funds, and the like. However, interest on debt to acquire or carry investments that produce tax-free income is not deductible at all. The annual investment interest deduction is limited to “net investment income,” which is the total taxable investment income reduced by tax-deductible investment expenses. Prior to the tax reform enacted in 2017, these expenses often included investment advisory fees that were part of miscellaneous itemized deductions. However, for years 2018 through 2025, the deduction of these types of expenses is suspended. Currently, the IRS’s instructions to Form 4952, Investment Interest Expense Deduction, list only depreciation and depletion as examples of eligible expenses, and most individuals typically won’t have these expenses. So, for most taxpayers, their investment interest deduction will be limited to the amount of their investment income. However, the investment interest deduction is only allowed to taxpayers who itemize their deductions on Schedule A.
Home mortgage interest – includes the interest on a taxpayer’s primary home and a single second home. However, the debt on which the interest is deductible is generally limited to $750,000 ($1 million for debt incurred before December 16, 2017) of home acquisition debt (debt used to purchase or substantially improve the home(s)). The acquisition debt must be secured by the home(s) to be deductible as home mortgage interest. In addition, home mortgage interest is only deductible by those who itemize their deductions. Interest paid on equity debt – such as debt that may result when acquisition debt is refinanced – is not deductible as home mortgage interest with a couple of exceptions.
o If the loan proceeds are used to make substantial improvements to the home, the debt is treated as acquisition debt and the interest on that debt would be deductible.
o If the amount of the new loan merely replaces the balance of the old acquisition debt, as may be the case when the original loan is refinanced only to take advantage of a lower interest rate and no cash (equity) is taken out, then the interest would continue to be deductible as home mortgage interest so long as the $750,000 or $1 million debt cap isn’t exceeded.
But to the extent the new loan is greater than the balance of the old acquisition loan and isn’t used for substantial home improvements or traceable to another deductible use, the interest on the excess debt isn’t deductible.
Note: the rules stated here are for federal tax purposes; state rules may be different.
Passive activity interest – includes interest on debt that's for business or income-producing activities in which the taxpayer doesn’t “materially participate” and is generally deductible only if income from passive activities exceeds expenses from those activities. The most common passive activities are probably real estate rentals. For rental real estate activities, there is a special passive loss allowance of up to $25,000 for taxpayers who are active, but not necessarily material, participants in the rental. The $25,000 phases out for taxpayers with adjusted gross income between $100,000 and $150,000.
Trade or business interest – includes interest on debts that are for activities in which a taxpayer materially participates. This type of interest can generally be deducted in full as a business expense, although the deduction is limited for taxpayers with average annual gross income for the prior three years exceeding $27 million. The details of this limitation are not covered in this article.
Educational loans – Interest paid on a qualified student loan may be claimed as an above-the-line deduction (i.e., itemizing isn’t required). The maximum deduction per year is $2,500. This is a per return limit, not a per student limit. Mixed-use loans don’t qualify. A “qualified student loan” is generally one used to pay higher education expenses, such as tuition, room and board, and related expenses, for attending post-secondary educational institutions, including certain vocational schools, and certain institutions offering postgraduate training, on behalf of the taxpayer, spouse, or any dependent of the taxpayer (at the time the loan is incurred). For 2022, the deduction is phased out when modified AGI is between $145,000 and $175,000 for joint filers and $70,000 to $85,000 for others, except the deduction is not allowed when filing using the married separate status or if the taxpayer is a dependent of someone else. Once the AGI reaches the upper amount, no deduction is allowed for that year.
Because of the variety of limits imposed on interest deductions, the IRS provides special rules to allocate interest expense among the categories. These “tracing rules,” as they are called, are generally based on the use of the loan proceeds. Thus, interest expense on a debt is allocated in the same manner as the allocation of the debt to which the interest expense relates. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures, i.e., by “following the money.”
These tracing rules, combined with the restrictions associated with the various categories of interest, can create some unexpected results. Here are some examples:
Example 1: A taxpayer takes out a loan secured by his rental property and uses the proceeds to refinance the rental loan and buy a car for personal use. The taxpayer must allocate interest expense on the loan between rental interest and personal interest for the purchase of the car, and even though the loan is secured by the business property, the personal loan interest portion is not deductible.
Example 2: A taxpayer takes out a loan secured by his rental property and uses the proceeds to finance a European vacation. The use of the funds was to pay for a vacation and thus the interest on the loan is nondeductible personal interest expense.
Example 3: The taxpayer owns a rental property free and clear and wants to purchase a home that he’ll use as his personal residence. He obtains a loan on the rental to purchase the home. Under the tracing rules, the taxpayer must trace the use of the funds to their use, and as the debt was not used to acquire the rental, the interest on the loan cannot be deducted as rental interest. The funds can be traced to the purchase of the taxpayer’s home. However, for interest to be deductible as home mortgage interest, the debt must be secured by the home, which it is not. Result: the interest is not deductible anywhere.
Example 4: The taxpayer uses her bank credit card to pay her son’s college tuition and related expenses as well as for purchasing clothing, food, household items, vacations, etc. None of the interest she pays on the credit card balance can be allocated to education interest since interest paid on mixed-use debt isn’t allowed for the student loan interest deduction. On the other hand, if she had one credit card that she used only for her son’s eligible education expenses, then the interest would be deductible as student loan interest if she didn’t exceed the modified AGI phaseout limit.
As you can see, it is very important to plan your financing moves carefully, especially when equity in one asset is being used to acquire another. Please call this office for assistance in applying the various interest limitations and tracing rules to ensure you don’t inadvertently get some unexpected results.
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