Among the itemized deductions on Schedule A of Form 1040, you’ll ﬁnd “Interest You Paid.” As you get your records together for tax preparation, you should realize that not all interest can be deducted on your return. Interest you paid last year on credit card debt generally isn’t deductible, for example. Interest deductions on Schedule A fall into two categories. You probably can deduct interest on debt related to your home, and you might be able to deduct interest on debt you incurred as part of your investment activity.
Mortgage interest debt
If you have borrowed money to buy, build or improve your home, you can deduct some or all of the interest you paid during 2015. A “home” can be a house or an apartment you own—even a trailer or a boat, as long as it has cooking, sleeping and toilet facilities. You can deduct the interest on two such homes.
Example 1: Warren Young owns a single-family home as well as a cabin on a nearby lake, which he uses on weekends. If Warren has mortgages on both homes, he typically can deduct all the interest he paid on those loans in 2015.
Going forward, suppose that Warren gets married in 2016, and his wife also owns a home. Assuming the couple ﬁles a joint income tax return in 2016, what mortgage interest can this three-home couple deduct?
They’ll be limited to the interest paid on two homes. If one home is debt-free, the couple can deduct the interest paid on the two home loans. If all three homes are mortgaged, the couple can deduct the interest on the two homes with the highest interest payments during the year.
Home Equity Debt
In addition to home acquisition debt, there is a second category of debt, home equity debt, which may give rise to deductible interest. Interest on home equity debt, which includes loans secured by the home but not necessarily used for any speciﬁc purpose, is deductible for balances up to $100,000 ($50,000 for married taxpayers ﬁling separately).
Example 2: Assume that Warren Young’s mortgages on his primary home and his vacation home total $900,000, and Warren also has a home equity loan secured by his primary home of $50,000. Warren can deduct all the interest he pays on both the mortgage loan and the home equity loan.
Million dollar limit
The deduction for interest paid on home acquisition debt is limited to interest paid on $1.0 million of debt ($500,000 for married taxpayers ﬁling separately) and, as noted previously, the deduction for home equity debt is limited to interest paid on $100,000 of debt ($50,000 for married taxpayers ﬁling separately). However, the IRS has ruled that it will treat home acquisition debt as home equity debt to the extent it exceeds $1 million or $500,000 for married taxpayers ﬁling separately, eﬀectively increasing the limit on home acquisition debt to interest paid on $1.1 million of debt or $550,000 of debt for married taxpayers ﬁling separately.
Example 3: Assume that Warren Young has an $800,000 balance on his primary home mortgage plus a $400,000 mortgage on his vacation home for a $1.2 million total, and he has no home equity debt. Warren’s deduction on Schedule A would be limited to the interest paid on $1.1 million of this debt. (If you are in such a situation, our oﬃce can calculate the allowable deduction.)
Don’t forget the AMT
The alternative minimum tax (AMT) rules for deducting mortgage interest are more restrictive than the regular tax rules. If you expect to be subject to the AMT, our oﬃce can determine whether the interest on home acquisition debt or home equity debt is deductible when calculating your AMT.
If you borrow money to make investments, the interest you pay on the loan may be deductible on Schedule A. Often, interest paid on a margin account at a brokerage ﬁrm will be classed as investment interest, but that’s not the only possible source. If you borrow to buy a parcel of land that you think will gain value, the interest you pay can be investment interest.
On Schedule A, investment interest can be listed up to the amount of taxable investment income you report.
Example 4: Stan Rogers had $1,200 of taxable investment income from bond interest in 2015 and $1,500 of interest on a margin loan. Stan can deduct $1,200 of margin interest on Schedule A of his tax return for 2015, oﬀsetting his $1,200 in taxable investment income. The unused $300 of investment interest expense can be carried over to a future year in which Stan’s taxable investment income exceeds his investment interest expense.
Note that the situation would be more complicated if all of Stan’s 2015 investment income came from dividends instead of interest. Assuming those dividends qualify for low tax rates of 0% to 20%, which generally is true, the dividends would not count as investment income for this purpose. In this situation, Stan could not deduct any of his investment interest expense.
However, Stan could elect to treat his dividends as nonqualiﬁed, which are taxable at higher rates. Then, Stan could deduct his investment interest expense.
Net capital gains (that is, net long-term capital gain less short-term capital losses) from the disposition of investment property are also not included in investment income. Like dividends, a taxpayer may elect to have net capital gains included in investment income, but the gains included in net investment income will be taxed at the higher ordinary tax rates.
There are times when electing to include dividends or net capital gains in income makes sense; if you have that choice, our oﬃce can help you make the most tax-eﬀective decision.