When to Deduct Interest Expenses on Income Taxes

Are you able to deduct interest expenses on your 2021 tax return (due by April 18, 2022)? It depends on the type of interest. Although there are some other special rules, expenses can generally be divided among five categories:

1. Mortgage interest: Frequently, itemizers can deduct the mortgage interest they paid during the year. To qualify, the loan must be a legal obligation secured by your principal residence or one other home (e.g., a vacation home). Then it depends on the type of debt.

Acquisition debt: This is debt incurred to buy, build or substantially improve a qualified home. Under the Tax Cuts and Jobs Act (TCJA), interest paid on the first $750,000 million of acquisition debt is deductible, down from $1 million (but certain older loans may be grandfathered).
Home equity debt: Other home debts (e.g., home equity loans and lines of credit) are generally treated as a home equity debt. Previously, the interest paid on the first $100,000 of home equity debt was deductible, but the TCJA suspends this write-off from 2018 through 2025.

Note that a home equity loan may qualify as acquisition debt if the loan proceeds are used to make substantial home improvements.

2. Investment interest: If you borrow funds for investment purposes, the interest paid on the loan is investment interest. The amount of investment interest you may deduct as an itemizer is generally limited to the amount of your “net investment income” for the year. Any excess is carried over to the next year.

Net investment income includes gross income from property held for investment such as interest, annuities and royalties, but not capital gains and qualified dividends. The maximum tax rate for long-term capital gain and qualified dividends is 15% (20% for high-income taxpayers). However, you can elect to count long-term capital gain and qualified dividends toward net investment income if you forfeit the preferential tax rate.

3. Business interest: The interest incurred by your business may be fully deductible. However, the TCJA imposes new limits on this deduction.

Currently, the annual deduction for business interest is capped at 30% of adjusted gross income (AGI). Key exception: A small business with average gross receipts of $25 million or less for the past three years (indexed to $26 million for 2021) is exempt from the 30%-of-AGI limit.

4. Student loan interest: A taxpayer legally obligated to repay a student loan can deduct up to $2,500 of the interest paid during the tax year, subject to a phase-out based on modified adjusted gross income (MAGI). This deduction is claimed “above the line,” so it reduces your AGI for other tax return purposes.

For 2021 returns, the phase-out occurs between $70,000 and $85,000 of MAGI for single filers and between $140,000 and $170,000 for joint filers.

5. Personal interest: Finally, if an interest expense doesn’t fall into one of the other categories, it is generally treated as nondeductible personal interest. This includes credit card charges incurred to buy personal items and interest paid on intra-family loans. Sorry—there is no deduction for these interest expenses.