Tax-Deductible Interest: Definition and Types That Qualify

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 their taxable income. Several types of interest are tax-deductible, including mortgage interest on a primary or second home, student loan interest, and interest on some business loans, including business credit cards.

Understanding Tax-Deductible Interest

Interest is the amount of money you pay a lender for the privilege of borrowing money or delaying the repayment of a debt. All loans incur interest, which the lender may roll into your monthly payment. For example, you pay back a portion of the principal (i.e., the amount you borrowed) plus interest every month with most mortgages. On the other hand, revolving loans—like credit cards—accrue interest only on unpaid balances.

To make certain loans more affordable, the IRS allows you to deduct several types of interest expenses, including:

• Investment interest
• Qualified mortgage interest (including points if you're the buyer)
• Student loan interest
• Non-farm business interest
• Farm business interest
• Interest related to income-producing activities

Of course, not all types of interest are deductible. Specifically, the IRS does not allow you to deduct personal interest, such as:

• The interest you pay on a loan to buy a car for personal use
• Credit card and installment loan interest on personal expenses
• Mortgage points (for sellers), service charges, credit investigation fees, and interest associated with tax-exempt income

Student Loan Interest Tax Deduction

While you can't deduct your student loans, you can get a tax break for the interest you pay by claiming the student loan interest deduction. You can generally deduct the smaller of $2,500 or the interest you actually paid during the year; however, the deduction may be gradually reduced or eventually eliminated depending on your filing status and modified adjusted gross income (MAGI):

To claim the deduction, you must meet all of the following conditions:

• You paid interest on a qualified student loan during the tax year
• You're legally obligated to pay interest on a qualified student loan
• Your filing status is not married filing separately
• Your MAGI is less than the annual limit
• Nobody else can claim you or your spouse (if you file jointly) as a dependent on their tax return
  

Additionally, the loan must pay for qualified educational expenses for you, your spouse, or your dependent during an academic period in which the student is enrolled at least part-time in a degree program. Quarters, trimesters, semesters, and summer-school sessions count as academic periods. Qualified expenses include:

• Tuition and fees
• Room and board included in the cost of attendance
• Books, supplies, and equipment
• Other necessary expenses (e.g., transportation)

If you paid at least $600 in student loan interest, you should receive Form 1098-E from your student loan servicer. The student loan interest deduction is taken as an income adjustment, so you don't need to itemize your deductions. Instead, you can enter the allowable amount directly on Form 1040 or 1040-SR.

Mortgage Interest Tax Deduction

You can deduct the mortgage interest you pay on the first $750,000 ($375,000 if married filing separately) of mortgage debt. If you bought the home before Dec. 16, 2017, the higher $1 million ($500,000 if married filing separately) limit applies. The loan must be secured by your main home or a second home.

According to the IRS, your main home is where you live most of the time, whether that's a house, cooperative apartment, condominium, mobile home, house trailer, or houseboat. A second home can include any other residence you own and treat as a second home, even if you don't use it during the year; however, if you rent out the property, you must use it for 14 days or at least 10% of the number of days you rent it—whichever is greater—for the interest to count as qualified residence interest. All homes must have sleeping, cooking, and toilet facilities.

Your lender will send you Form 1098 to report qualified mortgage interest and points. To claim the tax break, you must itemize your deductions on Schedule A of your 1040 or 1040-SR form. You can also deduct the mortgage interest you pay on a rental property, but you report it on Schedule E since it counts as a business expense.

Watch for Changes in What's Deductible

Interest deductions are subject to limitations and exclusions, which can change from year to year. For example, taxpayers used to be able to claim the mortgage interest deduction on the first $1 million of mortgage debt; however, the allowable amount is now just $750,000, thanks to the Tax Cuts and Jobs Act. Be sure you understand the rules and confirm your eligibility before claiming any deductions. When in doubt, consult with a qualified tax professional.

The Bottom Line

Tax-deductible interest allows you to reduce your taxes by claiming allowable borrowing expenses. Student loan interest is taken as an income adjustment so you don't need to itemize your taxes to benefit from this tax break.

However, deducting investment interest and mortgage interest requires itemizing your taxes on Schedule A. Given the size of the standard deduction, it may not be worth your while to deduct these costs. Do the math each year to see which approach will work best for you.