The Deductibility (Or Non-Deductibility) of Interest

Overview

Sometimes, I receive questions about the deductibility of interest.  Often, the question comes up when money is borrowed.  However, regardless of what the question relates to, the answer of whether interest is deductible can be complicated.  That’s because the answer depends on how the taxpayer plans on using the borrowed funds.  Are they used for business purposes?  Investment? Or will the use of the borrowed funds be solely for personal purposes?

The issue has also gotten attention lately because of discussions by some on the tax writing committees in the Congress about eliminating interest deductibility. 

Interest deductibility, that’s the topic of today’s post.

Personal Interest

Personal interest (such as that associated with car loans, home appliances and credit cards) is not deductible unless the debt is secured by a mortgage on the principal residence.  This exception for “qualified residence interest” applies for interest associated with the taxpayer's principal residence and one other residence selected by the taxpayer.  To qualify, the residence must be used by the taxpayer or a member of the family for more than the greater of two weeks or 10 percent of the number of days when the residence is rented for a fair rent to persons other than family members.  The maximum mortgage amount that interest can be claimed on is $1,000,000 of acquisition indebtedness.  In addition, an interest deduction is available for home equity indebtedness up to a $100,000 loan amount.  The deductions are on a per mortgage basis.

Investment Interest

Investment interest is deductible (for those taxpayers that itemize deductions) to the extent of the taxpayer's net investment income.  However, interest on debt associated with tax-free investments is not deductible.  Also, interest on debt associated with land used by a farmer or rancher for agricultural purposes is not investment interest – it’s business interest.  Similarly, the investment interest rules do not apply to any interest resulting from passive activities.  The term “passive activities” means any activity involving the conduct of a trade or business in which the taxpayer does not materially participate and includes any rental activity.  Crop share and livestock share leases with substantial involvement in decision making should be deemed businesses for this purpose.

Business Interest

Business interest is interest on debt associated with a business activity in which the taxpayer materially participates.  Business interest is fully deductible, and if it is associated with the farm or ranch, it should be taken as a deduction.  In 1993, the United States District Court for the District of North Dakota held that interest paid on an income tax deficiency attributable to income reported on Schedule F was business interest deductible on the Schedule F for the year it was paid.  Miller v. United States, 841 F. Supp. 305 (D. N.D. 1993). However, the trial court’s decision was overturned on appeal, and numerous federal courts have since upheld the IRS regulations that disallow the interest deduction in such situations. 

Passive Activity Interest

Interest on debt associated with a business (or other income-producing activity) in which the taxpayer doesn’t “materially participate” is deductible only if the income from passive activities exceeds expenses from those activities.  This can be an issue for taxpayers that are engaged in rental real estate activities.  There are special passive loss allowance rules that apply, but for interest on debt associated with these activities to be deductible, the income from the activity must exceed expenses.   

Classification of Interest

Given the different categories of interest and the various rules of deductibility associated with each category, it is crucial to properly classify interest in order to determine which rules of deductibility apply.  In general, the nature of interest is determined by examining of the use of the borrowed funds. This is known as the “tracing rule.”  For example, if the use of the borrowed funds is for personal purposes, the interest is personal.  Similarly, if borrowed funds are used to purchase a tractor, the interest is deductible business interest if the tractor is used in the taxpayer's farming or ranching business.  If funds are borrowed as a second loan for the purpose of paying interest on a prior debt, interest on the second loan is allocated to the same purposes as the first loan.  For example, if a second loan is contracted to pay the interest on a debt incurred to purchase the farm, the interest on the second loan is allocated to the purchase of the farm and is business interest.  Any compound interest is allocated in accordance with the original interest to the uses of the original debt.

Segregation of Interest

As a matter of planning, it is important for farmers borrowing funds to maintain separate bank accounts for the business and for family expenditures.  To maintain deductibility, loan proceeds should not be deposited in accounts from which non-business expenditures are paid.

Prepayment of Interest

Similar to the prepayment of inputs for the farming operation, the prepayment of interest used to be quite common.  Indeed, it was common for farmers and ranchers in the past to go to the bank or the Production Credit Association at the end of December and line up their credit for the following year and, at the same time, prepay a year's worth of interest or even more.  This is no longer permissible as interest cannot be prepaid.  Cash basis taxpayers of all types are essentially placed on accrual accounting for deducting prepayments of interest.  Interest is deductible in the year it is earned as the payment for borrowed funds.  Distortion of income is no longer a relevant consideration.

Deductibility of Points

While the general rule is that interest paid in advance must be deducted over the life of the loan, exception exists for points paid on indebtedness incurred in connection with the purchase or improvement of the taxpayer's principal residence. “Points” on indebtedness incurred in connection with the purchase or improvement of, and secured by, the principal residence continue to be deductible in the year of payment if it is an established business practice in the community to pay points on such loans and the amount of the payment does not exceed the amount generally charged in the area.  One “point” equals one percent of the loan.  A deduction may be claimed for points if paid by the seller.  An amount is considered paid by the seller if the buyer provides, from funds not borrowed, an amount at least equal to the points in the form of down payment, escrow deposits, earnest money or other funds paid at the closing.  However, this rule does not apply to refinancing loans or home improvement loans on the principal residence and to all loans that involve a residence other than the principal residence, although one court permitted a deduction for points paid in conjunction with refinancing a home mortgage.  Huntsman v. Comm’r, 905 F.2d 1182 (8th Cir. 1990).

Proper Handling of Year-End Interest Payments and Loan Rollovers

Late year-end payments pose special problems where interest is paid from proceeds of a new loan and the indebtedness continues.  An important factor in determining if interest payments to a lender are “paid” is whether the borrower exercised unrestricted control over the loan proceeds.  Interest is generally considered to be paid if the borrower has unrestricted control over the loan funds.  However, a taxpayer should avoid borrowing funds for interest payments from the same lender that furnished the original loan even if unrestricted control is maintained over the loan proceeds. See, e.g., Davison v. Comm’r, 141 F.3d 403 (2d Cir. 1998).  The IRS has indicated that an interest deduction will be denied if the taxpayer borrows funds from the same lender for the purpose of satisfying the interest obligation to that lender.  I.R.S. News Release IR 83-93 (July 6, 1983).

For loans of more than one year, the “original issue discount” rules authorize an interest deduction evenly over the life of the loan.

Conclusion

The proper characterization of interest is critical to understanding whether interest is deductible.  Have you been handling interest deductibility properly?