25. Interest Expense
Important Reminders
Personal interest. Personal interest is not
deductible. Examples of personal interest include interest on a loan to purchase an
automobile for personal use and credit card and installment interest incurred for personal
expenses. But you may be able to deduct interest you pay on a qualified student loan. For
details, see Publication 970, Tax Benefits for Education.
Limit on itemized deductions. Certain itemized deductions (including
home mortgage interest) are limited if your adjusted gross income is more than $137,300
($68,650 if you are married filing a separate return). For more information, see chapter
22.
Introduction
This chapter discusses interest. Interest is the amount you pay for the use of borrowed
money.
The types of interest you can deduct as itemized deductions on Schedule A (Form 1040)
are:
- Home mortgage interest, including certain points, and
- Investment interest.
This chapter explains these deductions. It also explains where to deduct other types of
interest and lists some types of interest you cannot deduct.
Use Table 25-1 to find out where to get more information on various types of
interest, including investment interest.
Useful Items
You may want to see:
Publication
- 936 Home Mortgage Interest Deduction
Home Mortgage
Interest
Generally, home mortgage interest is any interest you pay on a loan
secured by your home (main home or a second home). The loan may be a mortgage to
buy your home, a second mortgage, a line of credit, or a home equity loan.
You can deduct home mortgage interest only if you meet all the following conditions.
- You must file Form 1040 and itemize deductions on Schedule A (Form 1040).
- You must be legally liable for the loan. You cannot deduct payments you make for someone
else if you are not legally liable to make them. Both you and the lender must intend that
the loan be repaid. In addition, there must be a true debtor-creditor relationship between
you and the lender.
- The mortgage must be a secured debt on a qualified home. (Generally, your mortgage is a
secured debt if you put your home up as collateral to protect the interests of the lender.
The term qualified home means your main home or second home. For details, see
Publication 936.)
Amount Deductible
In most cases, you will be able to deduct all of your home mortgage interest. Whether
you can deduct all of it depends on the date you took out the mortgage, the amount of the
mortgage, and your use of its proceeds.
Fully deductible interest. If all of your mortgages fit into one or
more of the following three categories at all times during the year, you can deduct all of
the interest on those mortgages. (If any one mortgage fits into more than one category,
add the debt that fits in each category to your other debt in the same category.)
The three categories are:
- Mortgages you took out on or before October 13, 1987 (called grandfathered debt).
- Mortgages you took out after October 13, 1987, to buy, build, or improve your home
(called home acquisition debt), but only if throughout 2002 these
mortgages plus any grandfathered debt totaled $1 million or less ($500,000 or less if
married filing separately).
- Mortgages you took out after October 13, 1987, other than to buy, build, or improve your
home (called home equity debt), but only if throughout 2002 these
mortgages totaled $100,000 or less ($50,000 or less if married filing separately) and
totaled no more than the fair market value of your home reduced by (1) and (2).
The dollar limits for the second and third categories apply to the combined mortgages
on your main home and second home.
See Part II of Publication 936 for more detailed definitions of grandfathered,
home acquisition, and home equity debt.
You can use Figure 25-A to check whether your home mortgage interest is fully
deductible.
Figure 25-A. Is My Interest Fully Deductible?
Limits on deduction. You cannot fully deduct interest on a mortgage
that does not fit into any of the three categories listed above. If this applies to you,
see Part II of Publication 936 to figure the amount of interest you can deduct.
Special Situations
This section describes certain items that can be included as home mortgage interest and
others that cannot. It also describes certain special situations that may affect your
deduction.
Late payment charge on mortgage payment. You can deduct as home mortgage interest a late payment charge if it was not
for a specific service performed in connection with your mortgage loan.
Mortgage prepayment penalty. If
you pay off your home mortgage early, you may have to pay a penalty. You can deduct
that penalty as home mortgage interest provided the penalty is not for a specific service
performed or cost incurred in connection with your mortgage loan.
Sale of home. If you sell your home, you can deduct your home
mortgage interest (subject to any limits that apply) paid up to, but not including, the
date of sale.
Example. John and Peggy Harris sold their home on May 7. Through
April 30, they made home mortgage interest payments of $1,220. The settlement sheet for
the sale of the home showed $50 interest for the 6-day period in May up to, but not
including, the date of sale. Their mortgage interest deduction is $1,270 ($1,220 + $50).
Prepaid interest. If you pay
interest in advance for a period that goes beyond the end of the tax year, you must spread
this interest over the tax years to which it applies. You can deduct in each year
only the interest that qualifies as home mortgage interest for that year. However, see Points,
later.
Mortgage interest credit. You
may be able to claim a mortgage interest credit if you were issued a mortgage credit
certificate (MCC) by a state or local government. Figure the credit on Form
8396, Mortgage Interest Credit. If you take this credit, you must reduce your
mortgage interest deduction by the amount of the credit.
For more information on the credit, see chapter 38.
Ministers' and military housing allowance. If you are a minister or
a member of the uniformed services and receive a housing allowance that is not taxable,
you can still deduct your home mortgage interest.
Mortgage assistance payments. If you qualify for mortgage assistance
payments under section 235 of the National Housing Act, part or all of the interest on
your mortgage may be paid for you. You cannot deduct the interest that is paid for you.
No other effect on taxes. Do not include these mortgage
assistance payments in your income. Also, do not use these payments to reduce other
deductions, such as real estate taxes.
Divorced or separated individuals. If a divorce or separation
agreement requires you or your spouse or former spouse to pay home mortgage interest on a
home owned by both of you, the payment of interest may be alimony. See the discussion of Payments
for jointly-owned home in chapter 20.
Redeemable ground rent. If you
make annual or periodic rental payments on a redeemable ground rent, you can deduct them
as mortgage interest.
Payments made to end the lease and to buy the lessor's entire interest in the land are
not ground rents. You cannot deduct them. For more information, see Publication 936.
Nonredeemable ground rent. Payments on a nonredeemable
ground rent are not mortgage interest. You can deduct them as rent if they are a business
expense or if they are for rental property.
Rental payments. If you live in a house before final settlement on
the purchase, any payments you make for that period are rent and not interest. This is
true even if the settlement papers call them interest. You cannot deduct these payments as
home mortgage interest.
Mortgage proceeds invested in tax-exempt securities. You cannot
deduct the home mortgage interest on grandfathered debt or home equity debt if you used
the proceeds of the mortgage to buy securities or certificates that produce tax-free
income. Grandfathered debt and home equity debt are defined earlier under Amount
Deductible.
Refunds of interest. If you
receive a refund of interest in the same tax year you paid it, you must reduce your
interest expense by the amount refunded to you. If you receive a refund of interest
you deducted in an earlier year, you generally must include the refund in income in the
year you receive it. However, you need to include it only up to the amount of the
deduction that reduced your tax in the earlier year. This is true whether the interest
overcharge was refunded to you or was used to reduce the outstanding principal on your
mortgage.
If you received a refund of interest you overpaid in an earlier year, you generally
will receive a Form 1098, Mortgage Interest Statement, showing the refund in box
3. For information about Form 1098, see Mortgage Interest Statement, later.
For more information on how to treat refunds of interest deducted in earlier years, see
Recoveries in chapter 13.
Points
The term points is used to describe certain charges paid, or
treated as paid, by a borrower to obtain a home mortgage. Points may also be called
loan origination fees, maximum loan charges, loan discount, or discount points.
A borrower is treated as paying any points that a home seller pays for the borrower's
mortgage. See Points paid by the seller, later.
General rule. You generally cannot deduct the full amount of points
in the year paid. Because they are prepaid interest, you generally must deduct them over
the life (term) of the mortgage.
Exception. You can fully deduct points in the year paid if
you meet all the following tests. (You can use Figure 25-B as a quick guide to
see whether your points are fully deductible in the year paid.)
- Your loan is secured by your main home.
- Paying points is an established business practice in the area where the loan was made.
- The points paid were not more than the points generally charged in that area.
- You use the cash method of accounting. This means you report income in the year you
receive it and deduct expenses in the year you pay them. (If you want more information
about this method, see Accounting Methods in chapter 1.)
- The points were not paid in place of amounts that ordinarily are stated separately on
the settlement statement, such as appraisal fees, inspection fees, title fees, attorney
fees, and property taxes.
- The funds you provided at or before closing, plus any points the seller paid, were at
least as much as the points charged. The funds you provided do not have to have been
applied to the points. They can include a down payment, an escrow deposit, earnest money,
and other funds you paid at or before closing for any purpose. You cannot have borrowed
these funds from your lender or mortgage broker.
- You use your loan to buy or build your main home.
- The points were computed as a percentage of the principal amount of the mortgage.
- The amount is clearly shown on the settlement statement (such as the Uniform Settlement
Statement, Form HUD-1) as points charged for the mortgage. The points may be shown as paid
from either your funds or the seller's.
Figure 25–B. Are My Points Fully Deductible This Year?
Note. If you meet all of these tests, you can choose to either
fully deduct the points in the year paid, or deduct them over the life of the loan.
Home improvement loan. You can also fully deduct in the
year paid points paid on a loan to improve your main home, if tests (1) through (6) are
met.
 Second
home. The Exception does not apply to points you pay on loans secured by your second
home. You can deduct these points only over the life of the loan.
Exception does not apply. If you do not qualify under the
exception, or choose not to deduct the full amount of points in the year paid, see Points
in chapter 5 of Publication 535, Business Expenses, for the rules on when
and how much you can deduct. However, if the points relate to refinancing a home mortgage,
see Refinancing, later.
Amounts charged for services. Amounts charged by the lender for
specific services connected to the loan are not interest. Examples of these charges are:
- Appraisal fees,
- Notary fees,
- Preparation costs for the mortgage note or deed of trust,
- Mortgage insurance premiums, and
- VA funding fees.
You cannot deduct these amounts as points either in the year paid or over the life of
the mortgage. For information about the tax treatment of these amounts and other
settlement fees and closing costs, get Publication 530, Tax Information for First-Time
Homeowners.
Points paid by the seller. The term points includes loan
placement fees that the seller pays to the lender to arrange financing for the buyer.
Treatment by seller. The seller cannot deduct
these fees as interest. But they are a selling expense that reduces the amount realized by
the seller. See chapter 16 for information on the sale of your home.
Treatment by buyer. The buyer reduces the basis of the home
by the amount of the seller-paid points and treats the points as if he or she had paid
them. If all the tests under the Exception, earlier, are met, the buyer can
deduct the points in the year paid. If any of those tests is not met, the buyer deducts
the points over the life of the loan.
For information about basis, see chapter 14.
Funds provided are less than points. If you meet all the tests in
the Exception, earlier, except that the funds you provided were less than the
points charged to you (test 6), you can deduct the points in the year paid, up to the
amount of funds you provided. In addition, you can deduct any points paid by the seller.
Example 1. When you took out a $100,000 mortgage loan to buy
your home in December, you were charged one point ($1,000). You meet all the tests for
deducting points in the year paid, except the only funds you provided were a $750 down
payment. Of the $1,000 charged for points, you can deduct $750 in the year paid. You
spread the remaining $250 over the life of the mortgage.
Example 2. The facts are the same as in Example 1, except
that the person who sold you your home also paid one point ($1,000) to help you get your
mortgage. In the year paid, you can deduct $1,750 ($750 of the amount you were charged
plus the $1,000 paid by the seller). You spread the remaining $250 over the life of the
mortgage. You must reduce the basis of your home by the $1,000 paid by the seller.
Excess points. If you meet all the tests in the Exception, earlier,
except that the points paid were more than are generally paid in your area (test 3), you
deduct in the year paid only the points that are generally charged. You must spread any
additional points over the life of the mortgage.
Mortgage ending early. If you spread your deduction for points over
the life of the mortgage, you can deduct any remaining balance in the year the mortgage
ends. However, if you refinance the mortgage with the same lender, you cannot deduct any
remaining balance of spread points. Instead, deduct the remaining balance over the term of
the new loan.
A mortgage may end early due to a prepayment, refinancing, foreclosure, or similar
event.
Example. Dan paid $3,000 in points in 1993 that he had to spread
out over the 15-year life of the mortgage. He had deducted $1,800 of these points through
2001.
Dan prepaid his mortgage in full in 2002. He can deduct the remaining $1,200 of points
in 2002.
Refinancing. Generally, points you pay to refinance a mortgage are
not deductible in full in the year you pay them. This is true even if the new mortgage is
secured by your main home.
However, if you use part of the refinanced mortgage proceeds to improve your
main home and you meet the first six tests listed under Exception, earlier,
you can fully deduct the part of the points related to the improvement in the year you
paid them with your own funds. You can deduct the rest of the points over the life of the
loan.
Example 1. In 1991, Bill Fields got a mortgage to buy a home. In
2002, Bill refinanced that mortgage with a 15-year $100,000 mortgage loan. The mortgage is
secured by his home. To get the new loan, he had to pay three points ($3,000). Two points
($2,000) were for prepaid interest, and one point ($1,000) was charged for services, in
place of amounts that ordinarily are stated separately on the settlement statement. Bill
paid the points out of his private funds, rather than out of the proceeds of the new loan.
The payment of points is an established practice in the area, and the points charged are
not more than the amount generally charged there. Bill's first payment on the new loan was
due July 1. He made six payments on the loan in 2002 and is a cash basis taxpayer.
Bill used the funds from the new mortgage to repay his existing mortgage. Although the
new mortgage loan was for Bill's continued ownership of his main home, it was not for the
purchase or improvement of that home. He cannot deduct all of the points in 2002. He can
deduct two points ($2,000) ratably over the life of the loan. He deducts $67 [($2,000 ÷
180 months) × 6 payments] of the points in 2002. The other point ($1,000) was a fee for
services and is not deductible.
Example 2. The facts are the same as in Example 1, except
that Bill used $25,000 of the loan proceeds to improve his home and $75,000 to repay his
existing mortgage. Bill deducts 25% ($25,000 ÷ $100,000) of the points ($2,000) in 2002.
His deduction is $500 ($2,000 × 25%).
Bill also deducts the ratable part of the remaining $1,500 ($2,000 - $500) that must be
spread over the life of the loan. This is $50 [($1,500 ÷ 180 months) × 6 payments] in
2002. The total amount Bill deducts in 2002 is $550 ($500 + $50).
Limits on deduction. You cannot fully deduct points on a mortgage
unless the mortgage fits into one of the categories listed earlier under Fully
deductible interest. See Publication 936 for details.
Mortgage Interest Statement
If you paid $600 or more of mortgage interest (including certain
points) during the year on any one mortgage, you generally will receive a Form
1098, Mortgage Interest Statement, or a similar statement from the mortgage
holder. You will receive the statement if you pay interest to a person (including a
financial institution or a cooperative housing corporation) in the course of that person's
trade or business. A governmental unit is a person for purposes of furnishing the
statement.
You should receive the statement for each year by January 31 of the following year. A
copy of this form will also be sent to the IRS.
The statement will show the total interest you paid during the year. If you purchased a
main home during the year, it will also show the deductible points paid during the year,
including seller-paid points. However, it should not show any interest that was paid for
you by a government agency.
As a general rule, Form 1098 will include only points that you can fully deduct in the
year paid. However, certain points not included on Form 1098 also may be deductible,
either in the year paid or over the life of the loan. See Points, earlier, to
determine whether you can deduct points not shown on Form 1098.
Prepaid interest on Form 1098. If you prepaid interest in 2002 that
accrued in full by January 15, 2003, this prepaid interest may be included in box 1 of
Form 1098. However, you cannot deduct the prepaid amount for January 2003 in 2002. (See Prepaid
interest, earlier.) You will have to figure the interest that accrued for 2003 and
subtract it from the amount in box 1. You will include the interest for January 2003 with
the other interest you pay for 2003. See How To Report, later.
Refunded interest. If you received a refund of mortgage interest you
overpaid in an earlier year, you generally will receive a Form 1098 showing the refund in
box 3. See Refunds of interest, earlier.
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