Interest Deductions (Under Current Tax Law)

Definition

Under current tax law, interest deductions refer to the ability of taxpayers to reduce their taxable income by the amount of interest paid on various types of debt. The deductibility of interest is dictated by the nature of the debt incurred, such as investments, business activities, housing, or consumer expenses. The rules regarding the deductibility vary:

Investment Interest: Deductions are limited to net investment income, which includes interest, dividends, long-term capital gains, and certain income from oil and gas interests. However, it excludes rental income, passive activity income or loss, and interest paid to buy into a passive activity.
Construction Interest: Interest incurred during the construction and development of most real estate must be capitalized. Begin deductions over its depreciable life when the property is ready to be placed in service or sold.
Business Interest: Fully deductible if incurred in an active trade or business where the investor materially participates.
Housing Interest: Deductible for interest on up to $1 million of acquisition debt used for purchasing or improving a home, plus $100,000 of home equity debt. This can be claimed for a primary residence plus one vacation home if the owner uses it personally for the greater of 14 days or 10% of the rental period. Debt incurred before October 1987 is not subject to the $1 million limit.
Points on Mortgages: Points paid to acquire a principal residence may be deductible if customary in the geographic area. Points for refinancing must be amortized over the loan’s life.
Consumer Interest: Interest on credit cards and auto loans is not deductible.

Examples

Investment Interest Example:
- An investor incurs $10,000 in interest on a loan used to buy stocks and bonds. They earn $12,000 from dividends and interest. The $10,000 interest is deductible as it doesn’t exceed the net investment income.
Business Interest Example:
- A small business owner incurs $5,000 in interest on a loan used to expand their store. Since the owner participated actively in the business, the $5,000 interest is fully deductible.
Housing Interest Example:
- A homeowner incurs $15,000 in mortgage interest on a $900,000 loan used to purchase their principal residence. This interest is fully deductible under the $1 million acquisition debt threshold.

Frequently Asked Questions (FAQs)

Q1: Can I deduct interest on a loan used to invest in a rental property?

A1: Yes, interest paid on a loan to acquire a rental property is generally deductible as it qualifies as an investment interest, assuming it meets IRS guidelines.

Q2: How do the new tax laws affect mortgage interest deductions?

A2: The Tax Cuts and Jobs Act of 2017 reduced the mortgage interest deduction cap for new loans to $750,000 for acquisition debt. However, loans taken before December 15, 2017, remain under the previous $1 million cap.

Q3: Are the points I paid on my home mortgage tax deductible?

A3: Points paid to acquire a primary home mortgage are deductible in full in the year paid if they are customary in the area. Points for refinancing must be amortized over the life of the loan.

Dependent Life: The expected duration over which a fixed asset will be useful and thus can bear depreciation costs.
Adjusted Gross Income (AGI): A tax term for an individual’s total gross income minus specific deductions, pivotal in determining eligibility for certain tax credits and benefits.
Depreciation: The process of allocating the cost of a tangible asset over its useful life.

Online Resources

References

Internal Revenue Service. “Publication 936 (2021), Home Mortgage Interest Deduction.”
Internal Revenue Service. “Publication 535 (2021), Business Expenses.”
Tax Foundation. “The Tax Cuts and Jobs Act: Impact on Residential Property Taxes.”

Suggested Books for Further Studies

“Homeowner’s Guide to Tax Savings” by Julian Block
“Every Landlord’s Tax Deduction Guide” by Stephen Fishman
“1001 Tax Deductions and Tax Breaks 2023” by Barbara Weltman

Real Estate Basics: Interest Deductions Fundamentals Quiz

### What type of interest deduction is limited to net investment income? - [x] Investment Interest - [ ] Construction Interest - [ ] Housing Interest - [ ] Consumer Interest > **Explanation:** Investment interest deductions are limited to net investment income, which includes interest, dividends, and long-term capital gains. ### Are interest expenses incurred during construction deductible? - [ ] Yes, immediately - [x] Yes, but they must be capitalized - [ ] No, never - [ ] Only if below $10,000 > **Explanation:** Interest incurred during the construction of most real estate must be capitalized and deducted over its depreciable life, starting when the property is operational. ### Can consumers deduct interest on credit cards and auto loans? - [ ] Yes, fully deductible - [ ] Partially deductible - [ ] Depends on the amount - [x] No, not deductible > **Explanation:** Interest on credit cards and auto loans is considered consumer interest and is not tax-deductible. ### Is mortgage interest on a vacation home deductible? - [ ] No, never - [x] Yes, up to certain limits - [ ] Only if rented out - [ ] Only if lived in permanently > **Explanation:** Interest on up to $1 million of acquisition debt is deductible, including vacation homes, as long as they are personally used for the greater of 14 days or 10% of the rental period. ### Under what condition can points paid on a mortgage be deducted entirely in the year paid? - [x] If they are customary in the area and are paid for acquiring a principal residence - [ ] If over $5,000 - [ ] On any refinanced mortgage - [ ] Irrespective of location or purpose > **Explanation:** Points paid for a mortgage to acquire a principal residence may be deductible in full if they are customary in the geographical area. ### Are business interest expenses deductible if the investor does not materially participate in the business? - [ ] Yes, fully - [x] No, only if they materially participate - [ ] Depends on income level - [ ] Only if in the first year > **Explanation:** Business interest is only fully deductible if the investor materially participates in the active trade or business. ### For loans before October 13, 1987, what is the mortgage interest deduction cap? - [ ] $750,000 - [ ] Subject to current year limits - [x] There’s no cap - [ ] $500,000 > **Explanation:** For debt incurred before October 13, 1987, there is no $1 million limit for mortgage interest deductions. ### How does one amortize points paid for refinancing? - [x] Deduct evenly over the life of the loan - [ ] Deduct immediately - [ ] Deduct once half the loan term is completed - [ ] No amortization required, total deduction in the year paid > **Explanation:** Points paid for refinancing must be amortized over the life term of the loan. ### What is the maximum acquisition debt limit for mortgage interest deduction under the new law? - [x] $750,000 - [ ] $500,000 - [ ] $1,000,000 - [ ] No specified limit > **Explanation:** Under the Tax Cuts and Jobs Act, the cap for acquisition debt is reduced to $750,000 for new loans taken. ### Why is consumer interest non-deductible according to IRS guidelines? - [ ] Because it is politically motivated - [ ] Due to tech tax cards - [ ] To encourage mortgage liabilities - [x] IRS guidelines categorize it under non-deductible expenditures > **Explanation:** According to IRS guidelines, consumer interest such as credit card and auto loan interest is deemed non-deductible to discourage excessive consumer borrowing without appreciating assets.