Share Button

Interest Expense

Home Mortgage Interest

Deductions are allowed for “qualified residence interest” on a first or a second home (a taxpayer’s principal residence and one other residence). A home that is used for personal purposes for atleast 14 days in a year qualifies as a “second home”.

There are two categories of qualified residence interest:

Acquisition indebtedness:

Interest on up to $1,000,000 ($500,000 MFS) of acquisition indebtedness is deductible as qualified residence interest. Interest exceeding that amount is treated as personal interest, and as such, is not deductible. Acquisition indebtedness is debt that is:

  • Incurred in buying, constructing, or substantially improving the taxpayer’s principal and second home, and
  • Secured by home.
  • Points related to acquisition indebtedness are deductible immediately.
  • Refinancing points must be amortized over the period of the loan.

Home Equity Indebtedness

Debt that is secured by taxpayer’s principal or second residence, but is not “acquisition indebtedness” (i.e. not used to acquire, build, or improve the home), is classified as “home equity indebtedness.”

Maximum Amounts

The maximum amount that can eb treated as “home equity indebtedness” is the lesser of:

  • $100,000 ($50,000 MFS)
  • FMV of the property reduced by the amount of outstanding “acquisition indebtedness”

Purpose of the Loan

The proceeds of home equity loans may be used for any purpose (e.g. vacation, medical expenses etc.), but the interest is not deductible if the proceeds are used to buy securities or certificates that produce tax-free income.

Disallowed Home Equity Indebtedness

Interest on any excess amount is treated as personal interest.

Mortgage Insurance Premiums

Mortgage insurance premiums paid in connection with qualified acquisition debts are deductible in 2011 as home mortgage interest (phase-outs apply).

Investment Interest Expense

The investment interest deduction for individuals is limited to net (taxable) investment income.

Include as Investment (Taxable) Income

  • Interest and Dividends (“portfolio income”),
  • Dividends (portfolio or investment income);
  • Rents;
  • Royalties (in excess of expenses), and
  • Net long-term and short-term capital gains (only if taxpayer elects not to claim the reduced capital gains tax rate)

Exclude as Investment (Taxable) Income

Interest expense used to purchase tax-free bonds is not deductible (because the interest earned on the bonds is not taxable)

Include as Investment Interest Expense

  • Investment expenses (such as investment advice fees, safe deposit box rentals, etc.) other than interest are deductible on Schedule A as part of miscellaneous Itemized Deductions (subject to 2% of AGI).
  • Only those expenses deducted on Schedule A (i.e. those exceeding the 2% AGI) are used in calculating amount of net investment income which is the limit for investment interest deduction.

Exclude as Investment Interest Expense any Interest Expense taken into Account in determining Income or Loss from:

  • A passive activity. (Losses and credits can be carried forward indefinitely.)
  • Rental Real Estate (a passive activity) in which the taxpayer does not actively participate. (Interest expense when the taxpayer actively participates is treated separately.)

Disallowed Expense – Carry Forward

The excess of investment interest paid over the “allowed” investment interest can be carried forward indefinitely;

Personal (Consumer) Interest:

Personal interest includes interest on:

  • A personal note to a bank or person for borrowed funds
  • Life Insurance loans.
  • Bank Credit Cards or other revolving charge accounts.
  • A purchase of personal property such as autos, television sets, clothes etc.
  • Interest on federal, state, or local tax underpayments.

Personal interest is not deductible.

Prepaid Interest

(allocate to proper period)

Prepaid interest must be allocated over the period of the loan (for the taxpayer making the payments), even for cash basis taxpayer.

Educational Loan Interest

Educational loan interest is an adjustment. It is a deduction to arrive at adjusted gross income. It is not an itemized deduction.


Publication 936 – Home Mortgage Interest

Share Button