Interest is the amount paid for use of borrowed funds. The tax treatment of interest a taxpayer pays or accrues depends on the type of interest. In the context of individual income tax, most interest can be classified as one of five types:
* Qualified student loan interest;
* Qualified residence interest;
* Investment interest;
* Business interest; and
* Personal (consumer) interest. Qualified student loan interest and business interest are deductible before adjusted gross income (AGI, above the line), qualified residence interest and investment interest are deductible from AGI (below the line), and personal interest is not deductible.
There are timing issues on when to deduct qualified residence interest, investment interest, and business interest. Discussions and examples in this article will refer to "2017" and "2018 and after" because beginning in 2018, the old rules are suspended for eight years (2018 through 2025). (1) In theory, and as the Internal Revenue Code now reads, the 2017 rules will be restored in 2026.
Interest is classified by the way loan proceeds are used. (2) For instance, if loan proceeds are used to buy investment property or business property, the interest paid is classified as investment interest or business interest.
Qualified student loan interest
Up to $2,500 of interest on qualified student loans is deductible before AGI. (3) To be a qualified student loan, a loan must meet the following requirements: (4)
* It must be used for qualified education expenses, i.e., tuition, room, board, books, equipment, and other necessary expenses, such as transportation, and these expenses must be paid within a reasonable time before or after the taxpayer takes out the loan;
* It must be used for the qualified education expenses of the taxpayer, his or her spouse, or someone who is the taxpayer's dependent when the loan was taken out; and
* The student must be enrolled at least half-time in a program leading to a degree, including a graduate degree, or other recognized educational credential at an accredited college, university, vocational school, or other post-secondary educational institution that is eligible to participate in a U.S. Department of Education student aid program.
In calculating the student loan interest deduction, qualified education expenses must be reduced by, among other things: (5)
* Nontaxable employer-provided educational assistance benefits;
* Tax-free scholarships; and
* Veterans' educational assistance benefits.
In 2018, the deduction is phased out if modified adjusted gross income (MAGI) (6) is between: (7)
* $65,000 and $80,000 (for all taxpayers except married filing jointly), or
* $135,000 and $165,000 (for married taxpayers filing jointly).
The deduction for interest on a qualified student loan is not available for someone who (1) is claimed as another's dependent, (8) or (2) is married and files using the filing status of married filing separately. (9)
Example 1: G, a single taxpayer, paid $3,000 of interest on a qualified student loan. G has adjusted gross income (AGI) of $70,000. G can deduct interest of $1,667, calculated as follows: $2,500 maximum amount of student loan interest - $833 phaseout = $1,667 deductible student loan interest.
The $833 amount of the phaseout is calculated as $2,500 (maximum amount of student loan interest) x [$5,000 (amount AGI exceeds lower end of range) / $15,000 (range of income for phaseout)].
Qualified residence interest
Home mortgage interest on a qualified residence (10) is deductible from AGI as an itemized deduction. There are two types of qualified residence interest--acquisition indebtedness interest and home-equity indebtedness interest. (11) Acquisition indebtedness refers to debt that (1) is incurred to acquire, construct, or substantially improve a qualified residence, and (2) is secured by that qualified residence. (12) Home-equity indebtedness is (1) any debt that is not acquisition indebtedness, and (2) secured by a qualified residence. (13)
The law known as the Tax Cuts and Jobs Act (14) changed the rules regarding the deduction of qualified residence interest, decreasing the amount of acquisition interest that is deductible and suspending the deduction for home-equity indebtedness. (15) As a result of these changes, two sets of rules apply for qualified residence interest, one for years before 2018 and earlier years and one for 2018 through 2025.
Qualified residence interest, years before 2018
In years before 2018, interest is deductible on acquisition indebtedness up to $1,000,000 for single taxpayers, heads of household, and married taxpayers filing jointly and $500,000 for married taxpayers who file separately. (16) Interest on home-equity indebtedness is deductible to the extent the debt does not exceed the lesser of:
* The fair market value (FMV) of the residence, reduced by acquisition indebtedness, or
* $100,000 ($50,000 for married taxpayers who file separately). (17)
The total amount of acquisition indebtedness and home-equity indebtedness, the interest on which is deductible, cannot exceed $1,100,000 ($1,000,000 + $100,000). As the IRS ruled in Rev. Rul. 2010-25, a single mortgage loan that is secured by a qualified residence can be both acquisition indebtedness and home-equity indebtedness.
Example 2: Many years ago, a married couple took out a mortgage to acquire their residence. In November 2017, when their home is worth $600,000 and their first mortgage is $250,000, they take out a second mortgage of $110,000 to buy a pleasure boat.
On their joint return, they can deduct:
* All of the interest on the $250,000 first mortgage because the first mortgage is acquisition indebtedness; and
* The interest paid on $100,000 of the second mortgage of $110,000 because the second mortgage is home-equity indebtedness.
Qualified residence interest, years 2018 through 2025
For 2018 through 2025, interest is deductible on acquisition indebtedness up to $750,000 ($375,000 for married taxpayers filing separate returns). (18) However, the lower limitation does not apply to acquisition indebtedness incurred on or before Dec. 15, 2017. A taxpayer who enters into a written binding contract before Dec. 15, 2017, to close on the purchase of...