Keeping Interest Expense 100% Deductible
by A.J. Cataldo, Ph.D., CPA, CMA
Northeastern University – Boston
This article will review the five classifications or categories of interest expense and how you should arrange your personal, financial affairs to maximize the deductibility of interest expense. As you review these classifications, note that the general trend over recent decades has been to eliminate, reduce or place limitations on the amount of interest expense that may be deducted by the individual taxpayer. In fact, legislative proposals have been made with respect to a further reduction of the deductible amount of home mortgage interest, from about $1.1 million to about $300 to $400 thousand (late 2005). This is not likely to occur in the near-term, but you might view these and future proposals as a legislative “testing of the waters.” (These most recent efforts were motivated by the need to finance the costs of Katrina and its impact on New Orleans.)
The 5 categories of interest
There are 5 categories of interest:
- Business interest from a trade or business, fully deductible without limitation (see taxpayer Form 1040, Schedule C), however, the taxpayer must be “at risk” for the amounts financed;
- Passive activity interest (e.g., rental property), places limits on rental losses exceeding $25,000, where excess amounts are available for carry-forward to future years, and subject to the combination with other passive activity expenses and/or comparison against passive activity losses (see taxpayer Form 1040, Schedule E);
- Qualified residence interest, limited for high-income taxpayers in homes costing more than $1.1 million, but only available to taxpayers able to itemize their personal deductions (see taxpayer Form 1040, Schedule A);
- Investment interest, subject to net investment income limitations and/or available for carry-forward, and only available to taxpayers able to itemize their personal deductions (see taxpayer Form 4952 and Form 1040, Schedule A); and
- Personal interest is not deductible, except after 1997 for certain student loan interest (Form 1040, p. 1).
First, recall that personal interest was once deductible as an itemized deduction. Taxpayers were therefore provided with an additional economic incentive to finance the purchase of personal assets (e.g., home furniture, personal automobiles, etc.). From 1987 through 1990, the deductibility of personal interest was phased-out. Table 1 illustrates the form of this phase-out
Is there some magic way to deduct personal interest? No. Is there a way to arrange your financial affairs so that non-deductible personal interest is legitimately minimized or even eliminated and the deductibility of interest expense is maximized? Yes.
The general rule is BORROW FOR BUSINESS ASSETS; PAY CASH FOR PERSONAL ASSETS.
Consider three possible approaches:
- Taxpayer A pays cash for the $20,000 business asset; borrows $20,000 for the vacation.
- Taxpayer B pays cash for $10,000 of the business asset – borrowing the remaining $10,000; pays $10,000 cash for the vacation – borrowing the remaining $10,000.
- Taxpayer C pays cash for the $20,000 vacation; borrows $20,000 for the business asset.
Recall that personal interest is not deductible. Business interest is deductible. Therefore, in the case of Taxpayer A, none of the interest expense associated with borrowing (for the vacation) is deductible. In the case of Taxpayer B, one-half or 50% of the interest expense associated with borrowing (for the business asset) is deductible. Finally, in the case of Taxpayer C, all of the interest expense associated with borrowing (for the business asset) is deductible.
Assume that the interest expense for the year, at 10%, is $2,000 ($20,000 multiplied by 10%). Table 2 illustrates the calculation of deductible business interest for each taxpayer, under the assumption that all three taxpayers are in a 28% individual federal income tax bracket or rate and a 15.3% self-employment tax bracket, and assumes no state income tax, for a combined tax bracket of 43.3% (28% plus 15.3%).