Interest expense is the amount of money you pay for the use of borrowed funds. Certain types of interest expense may be deductible depending on where you use those borrowed money. Most consumers have various debts such as home mortgage debt, auto loans, credit card balances, student loans, business loans, and investment loans. Most of these interest expense are reported on your Schedule A – Itemized Deduction schedule, while some may be reported as adjustments to the gross income. Interest paid for business loans may be deducted on your Schedule C – Business expenses for your trade or business.
Interest Expense Paid You May Deduct
Home mortgage interest expense – pertains to the deduction of interest paid which are used to purchase your main home or second home. This may include the interest paid on the first and second mortgages, the home equity loans, points paid, and the qualified mortgage insurance premium. There are limitations on how much you can deduct.
Investment Interest – this is when you borrow funds in order to purchase properties you hold for investment purposes, the interest you paid is referred to as investment interest. You can deduct investment interest but subject to certain limitations but you cannot deduct interest you incurred to produce tax-exempt income. In other words, there is no double benefit taxations!! Examples of properties held for investment are properties that produces interest, dividends, annuities or royalties not derived in the ordinary course of trade of business. This also includes property that produces gain or loss from the sale or trade of property producing these types of income held for investment.
Example: Assuming that you got a good tip from your broker friend that the stock of Google, which is trading at $600 per share, may be going up like 20% in the next two months. However, you do not have any cash so you took out a cash advance of $10,000 from your credit card. The credit card interest charges 10%. The interest expense you paid for the credit card pertaining to the Google stock purchase can be deducted off your taxes.
Limitations on these deductions – In general, the deduction for investment interest expense is limited to the amount of your net investment income, which is your investment income less investment expenses. For example, you borrowed funds to buy XYZ stock and you earned $300 for the year. The interest you paid pertaining to the XYZ stock purchase is $200 and you paid broker’s fee of $50 and other fees amounting to $75 for a total investment expense of $325. Since your investment expense exceed your income by $25, you cannot take the full $200 interest deduction. Thus, you are only allowed to deduct $175.
Reporting Investment Interest Expense – Use Form 4952, Investment Interest Expense Deduction, to determine the amount of your investment interest expense deduction.
Interest Expense You May Not Deduct
Some interest expense are not deductible. Examples of this are
Personal Interest – any interest that is not home mortgage interest, investment interest, business interest or other deductible interest used for personal purposes. Examples of this are interest on car loans, interest on federal, state or local income tax, finance charges on credit cards, retail installment contracts, and revolving charge accounts incurred for personal expenses, late payment charges for utilities.
Interest to purchase or carry tax-exempt securities – tax-exempt securities means that the earning from this securities will not be taxed, therefore any expenses are also not tax deductible. This is called as no double benefit allowed.
Others – annual fees for credit cards, credit investigation fees, and loan fees.
Note: Student loan interest payments are not included in your itemized deductions schedule. Instead, they are reported as adjustment to your gross income. In other words, they are called as “above-the-line” deductions