Paying interest can get really expensive, so it’s natural to look for any method to reduce interest costs that you can find. One possible way you can defray some of your interest expenses is to take a tax deduction for the interest you pay. Unfortunately, deducting interest expenses is only an option on limited types of loans.
Until the Tax Reform Act of 1986, it was possible to deduct interest on more types of debt — including on credit card debt. Unfortunately, this mid-1980s tax reform law eliminated the deduction for personal interest, so credit card, personal loan, and medical loan interest can no longer be deducted on your tax return.
The good news is, there are still some situations when interest on debt is tax deductible. Here are four of them.
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1. Interest on mortgage and home equity debt
If you borrow for a home, you can take a mortgage interest deduction. You can take a deduction on interest on mortgages up to $750,000 if you purchased your home after Dec. 16, 2017, or on up to $1 million in mortgages if you bought your house prior to that December date.
You can also take a deduction on interest you pay on home equity loan debt, but only if you use the proceeds from the home equity loan to build, buy, or substantially improve the home that secures the home equity loan.
To claim a deduction for interest paid on mortgage debt or home equity loan debt, you need to itemize on your tax return. Because the standard deduction was nearly doubled beginning in 2018 as a result of the Tax Cuts and Jobs Act, it makes no financial sense for many taxpayers to itemize because the standard deduction exceeds the value of itemized deductions they could claim. So don’t assume that just because mortgage or home equity loan interest is tax deductible that you’ll always get to claim this deduction.
2. Interest on business debt
If you’re operating a business and you take out a loan for business purposes — including a line of credit or a mortgage on a business property — you can generally deduct the interest associated with the business loan.
However, there are certain conditions that must be met for the interest to be tax deductible. For example, you and the lender must both intend that the business loan be repaid, and you must be legally obligated to repay the debt. The lender you owe money to also must be a legitimate creditor, with an arms-length relationship — not a family member who loaned you money to start the business who doesn’t legitimately expect to be paid back.
You’ll need to be able to provide proof of the business debt in the event that you’re audited if you claim a deduction for interest paid. If your business has average gross receipts of $25 million or more, the deduction for interest on business debts is capped at 30% of your company’s earnings before interest, taxes, depreciation, and amortization.
3. Interest on margin debt
If you borrow money to invest, it’s possible you could claim a deduction on your taxes for any interest on margin debt that you incur. That’s because you can take a deduction for investment interest expenses as calculated on IRS Form 4952.
You’ll have to itemize on your taxes to claim this deduction. The value of the deduction is capped at the net taxable investment income you’re claiming during the tax year. If you don’t have net taxable investment income or if your investment income is lower than the margin interest you paid, you can carry over the remaining interest expense. This means you could potentially deduct the interest from net taxable investment income declared in the next tax year.
How much can you save if your debt is tax deductible?
The specific amount of savings that comes from being able to deduct interest you pay on debt will vary depending upon the amount of interest you’re able to deduct, as well as your tax bracket. Deductions reduce your taxable income, so you don’t pay taxes on the income you’d have otherwise been taxed on had you not claimed the deduction.
If you can reduce a very high income by $10,000 because you pay $10,000 in mortgage interest and the $10,000 in income otherwise would’ve been taxed at 35%, you’d save much more. In this scenario, your tax savings thanks to being able to deduct the interest on your mortgage debt would be $2,500.
The higher your tax bracket, and the more interest you pay on your debt, the more savings you’ll realize if your debt is tax deductible.
Understand your options for tax-deductible debt
Whenever possible, it makes sense to take out loans with tax-deductible interest. It would typically make no sense, for example, to use a personal loan to pay for school instead of a loan with tax-deductible interest. Of course, it’s important to look at the big picture and consider the loan terms and total costs of financing before you make a choice on which loan is right for you.
View more information: https://www.fool.com/the-ascent/banks/articles/when-is-interest-debt-tax-deductible/