Interest You
Can Deduct
You can generally deduct all interest you pay or accrue during the tax
year on debts related to your trade or business. Interest relates to your trade or
business if you use the proceeds of the loan for a trade or business expense. It does not
matter what type of property secures the loan. You can deduct interest on a debt only if
you meet all the following requirements.
- You are legally liable for that debt.
- Both you and the lender intend that the debt be repaid.
- You and the lender have a true debtor-creditor relationship.
Partial liability. If you are liable for part of a business debt,
you can deduct only your share of the total interest paid or accrued.
Example. You and your brother borrow money. You are liable for
50% of the note. You use your half of the loan in your business, and you make one-half of
the loan payments. You can deduct your half of the total interest payments as a business
deduction.
Mortgage. Generally, mortgage
interest paid or accrued on real estate you own legally or equitably is deductible.
However, rather than deducting the interest currently, you may have to add it to the cost
basis of the property as explained later under Capitalization of 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 or a similar statement. 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.
If you receive a refund of interest you overpaid in an earlier year, this amount will
be reported in box 3 of Form 1098. You cannot deduct this amount. For information on how
to report this refund, see Refunds of interest later in this chapter.
Expenses paid to obtain a mortgage. Certain expenses you pay to obtain a mortgage cannot be deducted as interest.
These expenses, which include mortgage commissions, abstract fees, and recording fees, are
capital expenses. If the property mortgaged is business or income-producing property, you
can amortize the costs over the life of the mortgage.
Prepayment penalty. If
you pay off your mortgage early and pay the lender a penalty for doing this, you can
deduct the penalty as interest.
Interest on employment tax deficiency. Interest charged on
employment taxes assessed on your business is deductible.
Original issue discount (OID). OID
is a form of interest. A loan (mortgage or other debt) generally has OID when its
proceeds are less than its principal amount. The OID is the difference between the stated
redemption price at maturity and the issue price of the loan.
A loan's stated redemption price at maturity is the sum of all amounts
(principal and interest) payable on it other than qualified stated interest. Qualified
stated interest is stated interest that is unconditionally payable in cash or
property (other than another loan of the issuer) at least annually over the term of the
loan at a single fixed rate.
You generally deduct OID over the term of the loan. Figure the amount to deduct each
year using the constant-yield method, unless the OID on the loan is de
minimis.
De minimis OID. The OID
is de minimis if it is less than one-fourth of 1% (.0025) of the stated redemption price
of the loan at maturity multiplied by the number of full years from the date of
original issue to maturity (the term of the loan).
If the OID is de minimis, you can choose one of the following ways to figure the amount
you can deduct each year.
- On a constant-yield basis over the term of the loan.
- On a straight-line basis over the term of the loan.
- In proportion to stated interest payments.
- In its entirety at maturity of the loan.
You make this choice by deducting the OID in a manner consistent with the method chosen
on your timely filed tax return for the tax year in which the loan is issued.
Example. On January 1, 2002, you took out a $100,000 discounted
loan and received $98,500 in proceeds. The loan will mature on January 1, 2012 (a 10-year
term), and the $100,000 principal is payable on that date. Interest of $10,000 is payable
on January 1 of each year, beginning January 1, 2003. The $1,500 OID on the loan is de
minimis because it is less than $2,500 ($100,000 × .0025 × 10). You choose to deduct the
OID on a straight-line basis over the term of the loan. Beginning in 2002, you can deduct
$150 each year for 10 years.
Constant-yield method. If
the OID is not de minimis, you must use the constant-yield method to figure how much you
can deduct each year. You figure your deduction for the first year using the
following steps.
- Determine the issue price of the loan. Generally, this equals the
proceeds of the loan. If you paid points on the loan (as discussed later), the issue price
generally is the difference between the proceeds and the points.
- Multiply the result in (1) by the yield to maturity.
- Subtract any qualified stated interest payments from the result in (2). This is the OID
you can deduct in the first year.
To figure your deduction in any subsequent year, follow the above steps, except
determine the adjusted issue price in step (1). To get the adjusted issue
price, add to the issue price any OID previously deducted. Then follow steps (2) and (3)
above.
The yield to maturity is generally shown in the literature you receive
from your lender. If you do not have this information, consult your lender or tax advisor.
In general, the yield to maturity is the discount rate that, when used in computing the
present value of all principal and interest payments, produces an amount equal to the
principal amount of the loan.
Example. The facts are the same as in the previous example,
except that you deduct the OID on a constant yield basis over the term of the loan. The
yield to maturity on your loan is 10.2467%, compounded annually. For 2002, you can deduct
$93 [($98,500 × .102467) - $10,000]. For 2003, you can deduct $103 [($98,593 × .102467)
- $10,000].
Loan or mortgage ends. If your loan or mortgage ends, you
may be able to deduct any remaining OID in the tax year in which the loan or mortgage
ends. A loan or mortgage may end due to a refinancing, prepayment, foreclosure, or similar
event.
 If you
refinance with the original lender, you generally cannot deduct the remaining OID in the
year in which the refinancing occurs, but you may be able to deduct it over the term of
the new mortgage or loan. See Interest paid with funds borrowed from original lender under
Interest You Cannot Deduct, later.
Points. The term points
is often used to describe some of the charges paid by a borrower when the borrower takes
out a loan or a mortgage. These charges are also called loan origination fees,
maximum loan charges, or premium charges. If any of these charges (points) are solely for
the use of money, they are interest.
Because points are prepaid interest, you cannot deduct the full amount in the year
paid. (For an exception for points paid on your home mortgage, see Publication 936.)
Instead, the points reduce the issue price of the loan and result in original issue
discount, deductible as explained in the preceding discussion.
Partial payments on a nontax debt. If you make partial payments on a
debt (other than a debt owed the IRS), the payments are applied, in general, first to
interest and any remainder to principal. You can deduct only the interest. This rule does
not apply when it can be inferred that the borrower and lender understood that a different
allocation of the payments would be made.
Installment purchase. If you make an installment purchase of
business property, the contract between you and the seller generally provides for the
payment of interest. If no interest or a low rate of interest is charged under the
contract, a portion of the stated principal amount payable under the contract may be
recharacterized as interest (unstated interest). The amount recharacterized as interest
reduces your basis in the property and increases your interest expense. For more
information on installment sales and unstated interest, see Publication 537.
Interest You
Cannot Deduct
Certain interest payments cannot be deducted. In addition,
certain other expenses that may seem to be interest are not, and you cannot deduct them as
interest.
You cannot currently deduct interest that must be capitalized, and you generally cannot
deduct personal interest.
Interest paid with funds borrowed from original lender. If you use
the cash method of accounting, you cannot deduct interest you pay with funds borrowed from
the original lender through a second loan, an advance, or any other arrangement similar to
a loan. You can deduct the interest expense once you start making payments on the new
loan.
When you make a payment on the new loan, you first apply the payment to interest and
then to the principal. All amounts you apply to the interest on the first loan are
deductible, along with any interest you pay on the second loan, subject to any limits that
apply.
Capitalized interest. You cannot
deduct interest you are required to capitalize under the uniform capitalization rules.
See Capitalization of Interest, later. In addition, if you buy property and pay
interest owed by the seller (for example, by assuming the debt and any interest accrued on
the property), you cannot deduct the interest. Add this interest to the basis of the
property.
Commitment fees or standby charges. Fees you incur to have business funds available on a standby basis, but not for
the actual use of the funds, are not deductible as interest payments. You may be
able to deduct them as business expenses.
If the funds are for inventory or certain property used in your business, the fees are
indirect costs and you generally must capitalize them under the uniform capitalization
rules. See Capitalization of Interest, later.
Interest on income tax. Interest charged on income tax assessed on
your individual income tax return is not a business deduction even though the tax due is
related to income from your trade or business. Treat this interest as a business deduction
only in figuring a net operating loss deduction.
Penalties. Penalties on underpaid deficiencies and
underpaid estimated tax are not interest. You cannot deduct them. Generally, you cannot
deduct any fines or penalties.
Interest on loans with respect to life insurance policies. You generally cannot deduct interest on a debt incurred
with respect to any life insurance, annuity, or endowment contract that covers any
individual unless that individual is a key person.
If the policy or contract covers a key person, you can deduct the interest on up to
$50,000 of debt for that person. However, the deduction for any month cannot be more than
the interest figured using Moody's Corporate Bond Yield Average-Monthly Average Corporates
(Moody's rate) for that month.
Who is a key person? A
key person is an officer or 20% owner. However, the number of individuals you can
treat as key persons is limited to the greater of the following.
- Five individuals.
- The lesser of 5% of the total officers and employees of the company or 20 individuals.
Exceptions for pre-June 1997, contracts. You can generally
deduct the interest if the contract was issued before June 9, 1997, and the covered
individual is someone other than an employee, officer, or someone financially interested
in your business. If the contract was purchased before June 21, 1986, you can generally
deduct the interest no matter who is covered by the contract.
Interest allocated to unborrowed policy cash value.
Corporations and partnerships generally cannot deduct any interest expense allocable to
unborrowed cash values of life insurance, annuity, or endowment contracts. This rule
applies to contracts issued after June 8, 1997, that cover someone other than an officer,
director, employee, or 20% owner. For more information, see section 264(f) of the Internal
Revenue Code.
Capitalization
of Interest
Under the uniform capitalization rules, you generally must capitalize
interest on debt equal to your expenditures to produce real property or certain
tangible personal property. The property must be produced by you for use in your trade or
business or for sale to customers. You cannot capitalize interest related to property that
you acquire in any other manner.
Interest you paid or incurred during the production period must be capitalized if the
property produced is designated property. Designated property is any of the following.
- Real property.
- Tangible personal property with a class life of 20 years or more.
- Tangible personal property with an estimated production period of more than 2 years.
- Tangible personal property with an estimated production period of more than 1 year if
the estimated cost of production is more than $1 million.
Property you produce. You produce property if you construct, build,
install, manufacture, develop, improve, create, raise, or grow it. Treat property produced
for you under a contract as produced by you up to the amount you pay or incur for the
property.
Capitalized interest. Treat capitalized interest as a cost of the
property produced. You recover your interest when you sell or use the property. If the
property is inventory, recover capitalized interest through cost of goods sold. If the
property is used in your trade or business, recover capitalized interest through an
adjustment to basis, depreciation, amortization, or other method.
Partnerships and S corporations. The interest capitalization rules
are applied first at the partnership or S corporation level. The rules are then applied at
the partners' or shareholders' level to the extent the partnership or S corporation has
insufficient debt to support the production or construction costs.
If you are a partner or a shareholder, you may have to capitalize interest you incur
during the tax year for the production costs of the partnership or S corporation. You may
also have to capitalize interest incurred by the partnership or S corporation for your own
production costs. To properly capitalize interest under these rules, you must be given the
required information in an attachment to the Schedule K-1 you receive from the partnership
or S corporation.
Additional information. The procedures for applying the uniform
capitalization rules are beyond the scope of this publication. For more information, see
sections 1.263A-8 through 1.263A-15 of the regulations and Notice 88-99. Notice 88-99 is
in Cumulative Bulletin 1988-2.
When To
Deduct Interest
If the uniform capitalization rules, discussed under Capitalization
of Interest, earlier, do not apply to you, deduct interest as follows.
Cash method. Under the cash method, you can generally deduct only
the interest you actually paid during the tax year. You cannot deduct a promissory note
you gave as payment because it is a promise to pay and not an actual payment.
Prepaid interest. You
generally cannot deduct any interest paid before the year it is due. Interest paid
in advance can be deducted only in the tax year in which it is due.
Discounted loan. If
interest or a discount is subtracted from your loan proceeds, it is not a payment of
interest and you cannot deduct it when you get the loan. For more information, see Original
issue discount (OID) under Interest You Can Deduct, earlier.
Refunds of interest. If
you pay interest and then receive a refund in the same tax year of any part of the
interest, reduce your interest deduction by the refund. If you receive the refund
in a later tax year, include the refund in your income to the extent the deduction for the
interest reduced your tax.
Accrual method. Under an accrual method, you can deduct only
interest that has accrued during the tax year.
Prepaid interest. You
generally cannot deduct any interest paid before it is due. Instead, deduct it in
the year in which it is due.
Discounted loan. If interest or a discount is subtracted
from your loan proceeds, it is not a payment of interest and you cannot deduct it when you
get the loan. For more information, see Original issue discount (OID) under Interest
You Can Deduct, earlier.
Tax deficiency. If you contest a federal income tax
deficiency, interest does not accrue until the tax year the final determination of
liability is made. If you do not contest the deficiency, then the interest accrues in the
year the tax was asserted and agreed to by you.
However, if you contest but pay the proposed tax deficiency and interest, and you do
not designate the payment as a cash bond, then the interest is deductible in the year
paid.
Related person. If
you use an accrual method, you cannot deduct interest owed to a related person who uses
the cash method until payment is made and the interest is includible in the gross
income of that person. The relationship is determined as of the end of the tax year for
which the interest would otherwise be deductible. If a deduction is denied under this
rule, the rule will continue to apply even if your relationship with the person ceases to
exist before the interest is includible in the gross income of that person. See Related
Persons in Publication 538.
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