April, 2005 Tax Newsletter

Maximize Your Interest Expense Deductions

A common area of confusion among my clients is the tax treatment of interest expense.  A very important side-bar issue is how to plan for obtaining the highest interest deductions.

Under the tax law there are five major categories of interest expense, each with different tax treatment.  These are business interest, mortgage interest, investment interest, passive activity interest, and personal (or consumer) interest.  I have listed them in descending order from the greatest tax benefit to the lowest benefit.  The objective is to allocate total borrowing among the categories of debt in such a way as to provide the largest deduction.  In doing so, we need to try to avoid incurring personal debt, as this provides no deduction.

Summary of tax treatment:

Business interest – fully deductible

Mortgage interest – deductible on up to $1,000,000 of borrowing to acquire or improve a residence, provided the residence secures the debt

Investment (often referred to as “portfolio”) interest) – deductible up to the amount of your net investment

Passive activity interest – generally deductible up to the amount of passive (e.g. rental) income

Personal interest – not deductible

Assume you wish to purchase a car or other personal consumer item.  As the interest on the consumer loan would be nondeductible,  we want to look for other ways to make the interest deductible.  For example, by taking out a home equity loan to buy the car or to pay off large personal credit card balances, you can convert nondeductible interest into tax advantaged interest.  This is because the home equity borrowing is deductible on up to $100,000, provided your residence secures the loan.  Another option would be to borrow, instead of using cash, to finance a business or investment expenditure and, instead, use the cash to buy the car.

The best planning opportunities for obtaining interest deductions lie with business interest, mortgage interest, and investment interest.

Business interest is deductible without limit provided the funds are used for valid business purposes.  This includes interest on funds used in a Schedule C business.  In this regard, borrowing to buy stock or other equity ownership in a business is considered investment interest, subject to limitations.

Mortgage interest – The $1,000,000 limitation referred to above can be allocated between two residences, so long as one of them is your personal residence.  If you have more than two residences, you can choose each year which one will be the second residence.  A home equity loan of up to $100,000 can be used for any purpose.  An advantage is that it normally carries a lower interest rate.  If the home equity borrowing exceeds $100,000 tracing rules described below apply.  The excess amount is business interest fi the excess funds are used for a business purpose or investment interest if traced to the purchase of an investment.

Investment interest – Investment income includes such items as dividends, interest, royalties, and short-term capital gains. These less investment expenses equals net investment income.  Excess investment interest may be carried forward and deducted in future years to the extent of net investment income in those years.  There is an election available to treat long-term capital gains as investment income (and thereby increase deductible investment income, but the trade-off is to lose the preferential tax treatment of the long-term gain.  IMPORTANT:  Tracing rules generally apply to interest deductions,  Therefore, the borrowed funds must be traceable to an investment in order for the interest to qualify as investment interest.  What often happens is that the borrowed funds get commingled in an account with other funds and the ability to trace may cause the loss of the deduction.  It is recommended that a separate account be used for the investment borrowing.

Passive interest – With certain exceptions, interest and other deductions from a passive activity such as a rental property can only be used to offset the income from the activity.   The excess passive loss is suspended and can be carried forward and used against passive income from the activity in future years.  Any suspended loss from the activity not used as an offset, can be deducted in full in the year of disposition of the activity, i.e. sale of the property.

It is highly recommended that you obtain professional tax advice when incurring debt in order to avoid losing or reducing your interest deductions.