What you need to know about interest deductions

Where does your interest lie? If interest you pay during the year rests in a tax-deductible category – or sprawls across several of them – you may be able to reduce your tax bill.

Interest expense can be sorted into five groups, each subject to different rules and restrictions.

1. Business interest. Interest paid on borrowed funds used for your business can offset business income. In some cases, the deduction may be less than the total amount you paid, such as when you use loan proceeds to buy a vehicle you drive both personally and for business.

2. Investment interest. The deduction for interest on loans you take out to purchase investment property is limited to “net investment income.” That’s the amount you earn from interest, dividends, and other investments, less costs incurred to produce the income.

3. Passive activity interest. When your participation in a business venture is limited, or if you own rental property, the amount you can deduct as interest expense may be subject to the passive activity rules. These rules restrict your current-year deduction to income from passive activities. Nondeductible amounts can be carried forward to future years.

4. Qualified residence interest. This category includes interest on debt secured by your main home and/or a second home. Mortgage interest is an itemized deduction and includes prepayment penalties, late payment charges, and prepaid interest.

5. Personal interest. Personal interest generally offers no tax benefit. An exception: interest paid on student loans, which can be deducted even if you don’t itemize. The maximum amount of student loan interest you can deduct each year is $2,500.

Please contact us to discuss the tax implications before you borrow money.