What Is Tax Deductible Interest?
Tax-deductible interest is 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 finance interest are not tax deductible.
Understanding Tax-Deductible Interest
The Internal Revenue Service (IRS) provides tax deductions that can reduce the taxable income of certain taxpayers. For example, an individual who qualifies for a $3,500 tax deduction can claim this amount against their taxable income of $20,500.
Their effective tax rate would then be calculated on $20,500 - $3,500 = $17,000, instead of $20,500. The interest payments made on certain loan repayments can be claimed as a tax deduction on the borrower’s federal income tax return. These interest payments are referred to as tax-deductible interest.
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 24% tax bracket and you have $1,000 in tax-deductible interest, you’ll save $240 on your tax bill. In effect, that loan only costs you $760 instead of $1,000.
Main Types of Tax Deductible Interest
Student loan interest tax deduction
There are certain deductions that qualified students can claim, one of which is the student loan interest deduction. Though a student cannot claim any student loans taken out for tuition, the interest that was paid on the loan during the tax year is deductible with the student loan interest deduction program. The loan has to be qualified, which, according to the IRS, means that the loan must have been taken out for either the taxpayer, his/her spouse, or his/her dependent.
Also, the loan must have been taken out for educational purposes during an academic period in which the student is enrolled at least part time in a degree program. A qualified loan is one that the taxpayer or his/her spouse is legally obligated to repay, and the loan must be used within a “reasonable period of time” before or after it is taken out. Generally, loans gotten from relatives or a qualified employer plan are not qualified loans.
The loan has to be used for qualified educational expenses, which include tuition, fees, textbooks, and supplies and equipment needed for the coursework, etc. The loan proceeds used for educational expenses must be disbursed within 90 days before the academic period starts and 90 days after it ends.
Room and board, student health fees, insurance, and transportation are examples of costs that do not count as qualified educational expenses under the student loan interest deduction program.
To qualify for the student loan interest deduction, the educational institution that the student is enrolled in has to be an eligible institution. An eligible school, under IRS rules, includes all accredited public, nonprofit, and privately owned for-profit postsecondary institutions that are eligible to participate in student aid programs managed by the U.S. Department of Education.
Mortgage interest tax deduction
The interest payments made on a mortgage can be claimed as a tax deduction on the borrower’s federal income tax return and are reported to the IRS on a form called Mortgage Interest Statement or Form 1098.
The standard Form 1098 reports how much an individual or sole proprietor paid in mortgage interest during the tax year. The mortgage lender is required by the IRS to provide this form to borrowers if the property that secures the mortgage is considered real property.
Real property is defined as land and anything that is built on, grown on, or attached to the land. The home for which the mortgage interest payments are made has to be qualified by IRS standards.
A home is defined as a space that has basic living amenities including cooking equipment, a bathroom, and a sleeping area. Examples of a home include a house, condominium, mobile home, yacht, cooperative, rancher, and boat. Also, qualified mortgages, according to the IRS, include first and second mortgages, home equity loans, and refinanced mortgages.
A taxpayer who deducts mortgage interest payments has to itemize their deductions. The total amount of mortgage interest paid in a year can be deducted on Schedule A. Itemized deductions are only beneficial if the total value of the itemized expenses is greater than the standard deduction. A homeowner whose itemized deduction including mortgage interest payments equals $5,500 may instead be better off going for their standard deduction—$12,550 for 2021—because the IRS only allows taxpayers to opt for one method.
A mortgage owner is also able to deduct points paid on the purchase of real property. Points are interest paid in advance before the due date of the payment or simply prepaid interest made on a home loan to improve the rate on the mortgage offered by the lending institution. However, having points reported on Form 1098 does not necessarily mean that the borrower qualifies for the deduction.
It’s a misconception that it’s a good idea to take out a loan that has tax-deductible interest because it will save you money on your tax bill. It’s common advice, for example, that homeowners should not pay off their 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 is bad advice 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 37% tax bracket, for every $1 you pay in interest, you will save $0.37 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.
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 (MAGI) cannot exceed a certain amount or you will not be eligible to claim the student loan interest deduction. So just because a certain expense falls into the category of tax-deductible interest does not always mean you will be able to deduct it on your tax return.