With interest rates rising, it’s increasingly important to make sure you’re taking advantage of all interest deductions you’re entitled to so you can avoid paying more in taxes than you need to. Three interest deductions are particularly important, according to J.P. Morgan, which explains how to use those deductions. The bank also describes how to preserve interest deductibility when switching from a floating-rate loan to a fixed-rate loan. Consider working with a financial advisor as you coordinate your borrowing and your tax planning.
Why Interest Deductibility Matters More Now
Given how much interest rates have risen in the first quarter of 2022, how you borrow can be as important as how much you borrow. By midyear the Federal Reserve had raised interest rates three times to counter the highest inflation in four decades. At least one more and perhaps two more hikes in the federal funds rate are expected.
U.S. tax laws do not treat all forms of interest equally. There are three key deductions that savers, business owners and investors should keep in mind. One is mortgage interest, another is borrowing to make taxable investments and the third is borrowing for a business.
Borrowing for a House
The government lets you deduct interest if a loan is used to build, buy or make capital improvements on a qualified property.
Taxpayers may deduct the interest on up to $750,000 of the principal indebtedness secured by one of their primary and one of their secondary residences. This deduction is also available – subject to certain limitations – for mortgage refinancing. The rules for older mortgages are slightly different: Mortgage interest due on debt incurred before Dec. 16, 2017, is deductible on up to $1 million of indebtedness. This deduction is also for refinancing debt.
Be careful to ensure that your loan proceeds can be traced to an identifiable deductible use, which is known as the “tracing doctrine,” and that you maintain evidence of this use.
Borrowing for Taxable Investments
Given the $750,000 principal limit on mortgage interest deductibility, people who are considering buying a more expensive home may not find the benefit as significant as the benefit of borrowing to invest in taxable securities. You can deduct interest paid on debt proceeds that can be traced to the purchase of taxable investments, up to all of your investment income for that year. Also, unlike with mortgages, there is no cap on the amount of principal indebtedness against which you can take this deduction, as long as you have enough investment income, from all sources, to use it against.
A bonus: If the investment interest paid in a given year is more than your investment income, any excess deduction can be carried forward indefinitely.
While rental income is generally not considered investment income, here are five types of income that the IRS does consider as investment income:
- Royalties and annuities
- Hedge fund and private equity income
- Interest, such as from corporate bonds
- Dividends that do not qualify for the preferential 20% top tax rate
- Preferentially taxed qualified dividends and long-term capital gains (to the extent the taxpayer elects to have them taxed at ordinary income rates)
Borrowing for a Business
If you materially participate in the operating business as a principal, the government lets you deduct interest on a loan used to buy equity or make additional capital contributions to an operating trade or a business organized as a flow-through entity. Such entities include S corporations, LLCs and partnerships.
“If the debt proceeds trace directly to operating business use, the principal’s business interest expense should be deductible directly against all of the taxpayer’s income, including non-business income,” J.P. Morgan stated in a recent article.
Excess deductions can be carried forward.
A Trap to Avoid
J.P. Morgan warns against a misconception some investors and business owners have regarding the deductibility of interest payments. That misconception is that any “swap” of a floating rate contract that exchanges a floating rate on a loan for fixed-rate periodic payments automatically preserves the deductibility of the interest that will be paid on the new, fixed-rate debt they have.
But that’s not necessarily true. To effectively fix a rate for tax purposes and ensure the deductibility of the interest paid, the swap must comply with a variety of additional legal requirements, including the contemporaneous execution of the floating-rate borrowing with the fixed-interest rate contract, as well as similar economic terms in both contracts. Consulting a financial advisor to see how to preserve interest deductibility can be a wise move.
Botton Line
As interest rates increase, so does the allure of optimizing your U.S. income tax deductions. Borrowing for a residence or a second residence, borrowing to make taxable investments and borrowing for a business you’re a principal in are all candidates for interest payment deductibility. But be careful as there are qualifications and limitations on some of these available deductions. Finally, make sure to keep evidence that your loan proceeds can be traced to an identifiable deductible use.
Tips on Taxes
- A financial advisor can help you minimize tax expenses as well as maximize investment returns. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Income in America is taxed by the federal government, most state governments and many local governments. The federal income tax system is progressive, so the rate of taxation increases as income increases. Use SmartAsset’s no-cost income tax calculator to get a quick estimate of what you will owe the federal government.
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