What Does Interest Deduction Mean?

Interest deduction causes a reduction in taxable income or revenues for taxpayers who pay certain types of interest. Interest deductions reduce the amount of income subject to tax. The three main types of interest deductions for individuals are for home mortgage and home equity loan interest, and margin account interest. Interest payments for a mortgage on a rental property can potentially also decrease an individual's gross income but do not in every situation. These deductions are allowed primarily to encourage home ownership and investment activity. Other interest deductions can come from the interest paid on student loans.

Businesses also receive a deduction from their taxable revenues in the form of bond interest. If a business has issued bonds, which is essentially a loan to the business, the organization will have to pay interest on those loans. The interest paid to bondholders reduces the business' revenue and therefore decreases the amount of taxable income the business will claim.

Interest Deduction Explained

Interest deductions for individuals face some limitations. Individual taxpayers must be able to itemize in order to claim either of the deductions listed above, and margin account interest is only deductible for amounts in excess of 2% of adjusted gross income. Additionally, margin loan interest is only tax-deductible if the loan is used to purchase taxable investments, and the deduction is limited to net investment income. However, once these conditions are met, it is possible to reduce or even eliminate one's taxable income if a sufficient amount of interest has been paid. To reduce gross income as the result of mortgage interest paid on an investment property, the expenses associated with the investment property must be greater than the rents collected from the property.

Interest deductions for businesses do not face the same issues. There are no floors to satisfy for a business paying interest to its bondholders. In the U.S., interest paid to bondholders is deducted from revenue along with other business expenses before taxable income, or profit, is determined. Essentially, the interest paid to bond investors is considered another type of business expense.