DEFINITION of 'Tax Deductible Interest'

A borrowing expense that a taxpayer can claim on a federal or state tax return to reduce taxable income. Types of interest that are tax deductible include mortgage interest for both first and second (home equity) mortgages, mortgage interest for investment properties, student loan interest, and the interest on some business loans, including business credit cards. Personal credit card interest, auto loan interest and other types of personal consumer interest are not tax deductible.

BREAKING DOWN 'Tax Deductible Interest'

Under President Ronald Reagan, the Tax Reform Act of 1986, a major set of changes to the federal tax code, phased out tax deductible personal credit card interest along with other types of personal loan interest deductions. The interest tax deductions that are still available are subject to limitations and exclusions. For example, your modified adjusted gross income cannot exceed a certain amount or you will not be eligible to claim the student loan interest tax deduction. So just because a certain expense falls into the category of tax deductible interest doesn’t always mean you will be able to deduct it on your tax return.

How much money can tax deductible interest save you on your tax return? It depends on your marginal tax rate, also called your tax bracket. For example, if you’re in the 25% tax bracket and you have $1,000 in tax deductible interest, you’ll save $250 on your tax bill. Effectively, that loan only cost you $750 instead of $1,000.

It’s a misconception that it’s a good idea to take out a loan that has tax deductible interest since it will save you money on your tax bill. It’s common advice, for example, that homeowners shouldn’t pay off the mortgage early because they will lose the mortgage interest tax deduction, or that taking out a mortgage is a good idea because it will lower your tax bill. This advice is bad because the amount of money you will pay in interest will far exceed your tax savings, even if you’re in the highest tax bracket. For example, if you’re in the 39% tax bracket, for every $1 you pay in interest, you will save 39 cents on your tax return. It’s clear that you’d be better off not paying any interest in the first place, which would save you the full $1.

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