Debts and taxes. They are both too high, right? But your debts can actually help keep the evil twin at bay. Why? At least some of that interest you pay each month is probably tax deductible.
In the “good old days”, taxpayers were allowed to deduct all their interest charges, even on credit card bills to pay for vacations, Armani suits and movie tickets. Then Congress figured it out and canceled that deal.
Now our beloved Internal Revenue Code only allows deductions for certain types of interest. This makes debt management more important than ever, because you’re essentially penalized by the IRS every time you have interest that falls into the non-deductible category. Here’s a summary of when you get tax relief for borrowing and when you don’t.
You are eligible for an itemized interest deduction on up to $1 million of mortgage debt used to acquire or improve your principal personal residence and another home. Mortgage interest on your third personal residence and beyond is considered a non-deductible personal expense.
So the tax trick of debt management is to: (1) make sure you don’t have more than $1 million in mortgage debt and (2) pay cash for your third, fourth, and fifth homes. . We should all have such financial challenges.
Interest on home equity loans
You are also allowed to claim an itemized deduction for home equity loan interest of up to $100,000, regardless of how you use the loan proceeds. The $100,000 figure is above and beyond the $1 million limit explained above. So you can have up to $1.1 million in debt on your primary and secondary residences and still deduct the interest.
Disclaimer: Interest on home equity loans is only deductible for Alternative Minimum Tax (AMT) purposes if you use the proceeds to acquire, build or improve a first or second residence. So if you’re in AMT mode, you need to understand that you may not get any tax benefits if you take out a $75,000 home equity loan to buy a BMW and pay for your kid’s braces. On the other hand, if you spend the $75,000 to install a pool and spa next to your house, you can deduct the interest under regular tax and AMT rules. Does that make any sense ? Of course not, but Congress does not ask our opinion on tax legislation.
Interest on holiday homes
For most people, the holiday home is the second home and the mortgage interest will prove to be deductible according to the rules explained above. However, when you rent the property part of the time, the tax rules become very tricky. However, you will generally be able to deduct all or most of the interest.
When you borrow money and use the proceeds to purchase taxable investment assets, the resulting interest is called investment interest expense. The most common example: interest on margin accounts with a brokerage firm.
You can deduct investment interest to the extent of your taxable investment income, i.e. interest, short-term capital gains, certain royalties, etc. If you don’t have enough investment income, the excess interest charges are carried over to the next tax year. Hopefully, you will have enough investment income that year to claim your write-off. If this is not the case, the postponement procedure repeats itself. And so on.
You can also choose to treat all or a portion of your long-term capital gains and eligible dividends as investment income. The benefit of making this election is that it allows you to currently deduct a greater portion of your investment interest expense. The downside is that the amount of long-term gains and dividends treated as investment income is taxed at your normal rate (which can be as high as 39.6%) instead of the normal rate of 15% or 20%.
If you have investment interest, complete IRS Form 4952 (Investment Interest Expense Deduction) to calculate your write-off. You also use this form to indicate the amount of your long-term capital gains and eligible dividends, if any, that you want to treat as investment income.
What about interest on loans used to purchase tax-free investments, such as municipal bonds or municipal bond funds? Not deductible. Logically enough, the government won’t let you write off interest on debts used to generate untaxed income.
So if your investment strategy requires borrowing, the tax trick is to spend the proceeds of debt to buy taxable investments and use the cash to pay for non-taxable investments.
Interest on university loans
Not too long ago, Congress finally gave us some much-needed tax relief of up to $2,500 in annual interest on loans used to pay for college. But the deduction comes with limits, and high-income earners won’t be eligible (surprise). If you fall into the ineligible category, consider taking out a home equity loan instead. You have a good chance of being able to deduct the interest, as explained above.
Interest on 401(k) loans
This is generally non-deductible regardless of how you use the money. Sorry. But that’s not really that bad, because you’re basically paying interest for yourself. The potential downside of using this particular line of credit is that you have to immediately repay the loan if you leave the business. If you don’t, you’ll be taxed as if you received a distribution equal to the loan balance. When this occurs before age 59.5, you will generally be subject to a 10% penalty tax. So, in general, you shouldn’t even think about taking out a 401(k) loan unless you’re sure you can pay it back on time and in full.
Interest on car loans, credit cards and other “consumer debt”
Unless you’re borrowing to fund a business expense, like a car used in your sole proprietorship, you can usually forget about the tax breaks.
That’s why it’s often advisable to take out a home equity loan and use the money to pay off credit card balances and car loans. You may be able to convert high non-deductible interest charges into relatively low, fully deductible interest charges. If so, this procedure is an excellent debt management system. Just be sure to read the previous caveats regarding the deductibility issue.
What happens when you borrow money and use it to finance your small business? Interest is generally fully deductible, like any other business expense. Before jumping for joy at the apparent simplicity of the previous sentence, be aware that the IRS has a complicated set of rules that essentially require you to trace debt proceeds for business purposes. If this applies to you, be sure to schedule a conversation with your friendly tax professional to discuss what exactly is needed to lock in your write-offs.
–Bill Bischoff is a Chartered CPA with over 30 years of experience as a tax practitioner. He lives and works in Colorado Springs, Colorado.
–This article was previously published on MarketWatch.
Copyright ©2022 Dow Jones & Company, Inc. All rights reserved. 87990cbe856818d5eddac44c7b1cdeb8