Deposit Interest into Five Tax Buckets

Interest rates rise and fall periodically, but the tax rules for deducting interest expenses remain the same — unless Congress changes them. Generally, the current rules have been in place for years, although the Tax Cuts and Jobs Act of 2017 (TCJA) did include some significant modifications.

Whether or not you can deduct interest expenses, and how much, depends on the type of expense. There are five "buckets" that interest expenses may be deposited into based on the use of the proceeds. Here's a brief overview of the main rules.

1. Mortgage interest

This is often one of the biggest write-offs available to taxpayers who itemize. To qualify for a deduction, the mortgage must be secured by your principal residence or one other home (for example, a vacation home). Plus, you must be legally obligated to pay the mortgage.

There are two types of mortgage interest for tax deduction purposes.

Acquisition debt. This includes debt incurred to buy, build, or substantially improve a qualified residence. Under the TCJA, interest paid on up to $750,000 of acquisition debt is deductible from 2018 through 2025 (down from $1 million under prior law). However, the prior $1 million limit is grandfathered for loans made prior to December 16, 2017.

Home equity debt. Any other mortgage debt — including home equity loans and lines of credit — is treated as a home equity debt. Prior to the TCJA, the interest paid on up to $100,000 of home equity debt was deductible, but this write-off has been suspended from 2018-2025. However, if you borrow money through a home equity loan or line of credit and use the proceeds for significant home improvements, the debt can be treated as an acquisition debt instead of a home equity debt because it's incurred to "substantially improve" a qualified residence. Accordingly, you may add the mortgage interest to your deductible total if you itemize deductions. Click here for more information from the IRS.

2. Investment interest

If you borrow money for investment purposes, you generally can deduct the interest as investment interest. But this deduction, which can only be claimed by itemizers, is limited to the amount of your annual net investment income. Any excess is carried over to the next year.

"Net investment income" includes gross income from property typically held for investment purposes like interest income, annuities, and royalties. Key point: You can't count tax-favored long-term capital gains and qualified dividends unless you forfeit their preferential tax treatment on your tax return for the year.

What are you giving up? The maximum tax rate on most long-term capital gains and qualified dividends is currently 20% (15% for most taxpayers).

Good news: This is NOT an all-or-nothing proposition. You can cherry-pick the long-term capital gains and qualified dividends you want to be covered by the election. Ask your tax professional to look at your portfolio to see if this is an option for you at tax return time.

Other special rules apply to so-called "passive activity" interests. Briefly stated, if an activity is characterized as a passive activity in which you don't actively participate, current deductions are limited to income generated by passive activities. Real estate is automatically treated as a passive activity, but a limited write-off may be available. Consult with your professional tax advisor for more details.

3. Business interest

For decades, interest incurred for business reasons was fully deductible, without any restrictions. However, the TCJA has limited the deduction to net interest up to a specified percentage of the employer's adjusted taxable income (ATI) for the year. Currently, the limit is 30% of ATI.

"Net interest" is the amount of interest you've paid or accrued during the year, less the amount of interest income included in your taxable income for the year. ATI is your business income without regard to:

Income, deduction, gain, or loss not properly allocable to a business

Business interest income and expense.

Net operating losses (NOLs).

The qualified business income (QBI) deduction.

Note that prior to 2022, ATI also included deductions allowable for depreciation, amortization, or depletion. This category has been removed.

Key point: A small business with average gross receipts of $25 million or less for the last three years (indexed to $29 million for 2023) is exempt from the 30%-of-ATI limit. So, your business may not be penalized if you can squeeze under that threshold.

4. Student loan interest

Assuming you meet certain requirements, you may deduct up to $2,500 of the annual interest paid on student loans, subject to a phase-out based on your modified adjusted gross income (MAGI). The deduction is claimed "above the line," so it's available whether or not you itemize. However, to be eligible for this deduction, you must be legally obligated to repay the loan. Thus, parents can't claim the deduction for a child who is liable for the payments.

If you still qualify, the loan must be a legitimate arrangement to borrow money to pay for qualified education expenses, such as the following:

• Tuition
• Room and board
• Books, supplies, and equipment
• Transportation
• Other fees

For 2023, the phase-out occurs between $75,000 and $90,000 of MAGI for single filers and between $150,000 and $180,000 for joint filers.

5. Personal interest

Finally, if an interest expense doesn't fit into one of the other baskets, it is generally treated as personal interest. Personal interest is nondeductible.

This includes credit card or loan charges incurred to buy items of a personal nature, like a non-business car or a vacation. But as seen above, interest incurred on a student loan may be deductible under certain circumstances if you qualify.

Usually, the nature of an interest expense is clear, depending on the use of the proceeds. But if the borrowed funds are commingled with other money in a bank account, the funds must be divided among the different buckets based on complex IRS rules. To avoid any hassles, it makes sense to keep the proceeds of loans in separate accounts, with each one designated for a specific purpose.

Caution: It's easy to be tripped up by the tax rules in this area. Your professional tax advisor can provide the guidance that you need.