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A Roundup of Tax Law Rules for Deducting Interest Payments

[caption id="attachment_3519" align="alignnone" width="620"] Sidney Kess[/caption] Interest rates are on the rise, albeit slowly. Still, individuals and businesses with debt can reduce the cost of borrowing if they can deduct their interest payments. The tax law has a patchwork quilt of rules for deducting interest. Some of the rules have been changed by the Tax Cuts and Jobs Act of 2017 (TCJA), while other rules remain unchanged. Here is a roundup of the rules for deducting interest payments.

Determining the Type of Interest

The tax law has various rules for deducting interest, depending on the type of interest involved. There are six categories:

  • Personal interest
  • Qualified residence interest
  • Student loan interest
  • Investment interest
  • Passive activity interest
  • Business interest

The classification of interest depends on the purposes for which the funds are used. Tracing rules are used for classification purposes (Reg. Sec. 1.163-8T). For example, if an individual obtains a personal loan from a friend to start a sole proprietorship, the interest is business interest.

Personal Interest

Generally, no deduction is allowed for personal interest, also referred to as consumer interest (Code Sec. 163(h)(2)). Thus, no deduction is allowed for interest on personal credit card debt or a personal car loan. Also no deduction is allowed for interest on unpaid federal income taxes (Code Sec. 163(k)). This includes interest on taxes related to Schedule C for sole proprietors (Robinson III, 119 TC 44 (2002)). The reason: these taxes are viewed as a personal obligation, and not a deductible business expense. The only exceptions for deducting personal interest are those for qualified residence interest and student loan interest explained below.

Home Mortgage Interest

An itemized deduction can be claimed for qualified residence interest despite it clearly being personal interest (Code Sec. 163(h)(3)). Qualified residence interest is interest on a loan secured by a principal residence plus one other personal residence to buy, build or substantially improve the home. There is a limit on how much indebtedness can be taken into account:

  • For mortgages incurred on or before Dec. 15, 2017: $1 million ($500,000 for a married person filing separately). The limit also applies to anyone with a binding contract by this date to close on the purchase of a principal residence before Jan. 1, 2018, and who does so before April 1, 2018.
  • For mortgages incurred after Dec. 15, 2017: $750,000 ($375,000 for a married person filing separately)

If a mortgage in place on Dec. 15, 2017, is refinanced, the new debt is treated as acquisition indebtedness. However, the new debt will qualify as such only up to the amount of the balance of the old mortgage principal just before the refinancing. No deduction is allowed for debt on a home equity loan in 2018 through 2025, regardless of when the loan was obtained. However, if the proceeds are used to substantially improve the residence (e.g., build an extension on the home), the debt can be treated as acquisition indebtedness (subject to the overall dollar limit) (IR-2018-32, 2/21/18). There had been a rule allowing mortgage insurance premiums to be treated as deductible interest by those with adjusted gross income below set limits (Code Sec. 163(E)). This rule expired at the end of 2017, but could be extended by Congress for 2018.

Student Loan Debt

According to the Federal Reserve (https://fred.stlouisfed.org/series/SLOAS), as of the first quarter of this year there was more than $1.5 trillion of student loan debt outstanding. However, the tax law greatly restricts the amount of interest that can be deducting on this debt. The maximum annual deduction is capped at $2,500. In addition, only those with modified adjusted gross income (MAGI) below a set amount can claim any write off. For 2018, the deduction begins to phase out for individuals with MAGI over $65,000 ($135,000 for joint returns), and is completely phased out when MAGI reaches $80,000 ($165,000 for joint returns). The MAGI limits are adjusted annually for inflation. The $2,500 deduction limit is fixed. There is a bill pending in Congress (H.R. 3573) (https://www.congress.gov/bill/115th-congress/house-bill/3573/text) that would raise the annual interest deduction limit to $7,500 ($15,000 for joint returns) and increase the MAGI threshold to start at $100,000 ($200,000 for joint filers). While referred to the Ways and Means Committee last year, it has not gained any traction.

Investment Interest

Individuals who borrow money to make investments in stocks, bonds, and other similar securities can deduct the interest if they itemize personal deductions rather than taking the standard deduction amount. The amount of investment interest is currently deductible only to the extent of net investment income (investment income minus investment expenses other than the interest expense) (Code Sec. 163(d)). Investment income and investment expenses from passive activities are not taken into account for this purpose; they are subject to the passive activity loss rules discussed next (Code Sec. 469). Unused investment interest can be carried forward indefinitely and used in future years, subject to the extent of net investment income limit. Form 4952, Investment Interest Expense Deduction, must be filed to figure the deductible amount of investment interest (with some exceptions). However, no interest deduction can be claimed for borrowing to buy or carry tax-exempt investments, such as municipal bonds (Code Sec. 265(a)(2)).

Passive Activity Interest

Interest related to a passive activity, such a rental real estate, is deductible according to the passive activity loss rules (Code Sec. 469). In general, total expenses from passive activities, including interest, are deductible only to the extent of passive activity income for the year. However, there are various exceptions that may allow for greater write-offs. For example, an individual who actively participates in a rental real estate activity can deduct losses (including interest) in excess of passive activity income up to $25,000 annually, provided adjusted gross income does not exceed a threshold amount.

Business Interest

Until now, business interest has been fully deductible, assuming the debt to equity ratio was sufficient. The TCJA imposes a new business interest limitation starting in 2018 (Code Sec. 163(j)). Generally, this means interest is deductible only to the extent of the sum of:

  • Business interest income for the year
  • 30 percent of adjusted taxable income for the year
  • Floor plan financing interest (used by car dealers and certain other businesses)

Disallowed interest can be carried forward and treated as business interest paid in the succeeding taxable year. Small businesses are exempt from this limitation. “Small” for this purpose means having average annual gross receipts for the three prior years not exceeding $25 million (the gross receipts test is in Code Sec. 448(c)). Farming and real property businesses can elect to be exempt from the interest deduction limitation. Making this election means that real property must be depreciated using the Alternative Depreciation System (ADS) (i.e., slower write-offs). The IRS has provided interim guidance on the business interest limitation (Notice 2018-28, IRB 2018-16, 492). The guidance says that all interest expense of C corporations is treated as business interest; different rules apply to S corporations and partnerships. It also hints at the regulations that the Treasury expects to issue for affiliated groups and certain other aspects of the new law.

Conclusion

The tax rules for deducting interest are complicated. And they could be changed in the future. Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink and senior consultant to Citrin Cooperman & Co.