When are interest payments deductible?
The Tax Cuts and Jobs Act (TCJA) has made a significant impact — both directly and indirectly — on the deductibility of interest expense. Here’s a quick review of where things now stand.
5 types of interest
Interest expense generally falls within one of five categories:
- Business interest,
- Qualified residence interest,
- Investment interest,
- Qualified student loan interest, and
- Personal interest.
Let’s focus on the four categories of nonbusiness interest. (The TCJA places new limits on business interest deductions for businesses with average gross receipts over $25 million.)
Qualified residence interest
The TCJA affects interest on residential loans in two ways. First, by nearly doubling the standard deduction and placing a $10,000 cap on deductions of state and local taxes, the act substantially reduces the number of taxpayers who itemize. This means that fewer taxpayers will benefit from mortgage and home equity interest deductions. Second, the act places new limits on the amount of qualified residence interest you can deduct, from 2018 through 2025.
Previously, taxpayers could deduct interest on up to $1 million in acquisition indebtedness ($500,000 for married taxpayers filing separately) and up to $100,000 in home equity indebtedness ($50,000 for married taxpayers filing separately).
Acquisition indebtedness is debt that’s incurred to acquire, build or substantially improve a qualified residence, and is secured by that residence. Home equity indebtedness is debt that’s incurred for any other purpose (such as buying a boat or paying off credit cards), and is secured by a qualified residence. A single mortgage could be treated as both acquisition and home equity indebtedness, allowing taxpayers to deduct interest on debt up to $1.1 million.
The TCJA reduced the deduction limit for acquisition indebtedness to interest on up to $750,000 in debt and eliminated the deduction for home equity indebtedness altogether, through 2025. The new limit on acquisition indebtedness doesn’t apply to debt incurred on or before December 15, 2017, subject to an exception for mortgages that were incurred on or before April 1, 2018, in certain circumstances ― specifically, for debt incurred pursuant to a written binding contract to purchase a qualified residence executed before December 15, 2017, and scheduled to close before January 1, 2018 (so long as the purchase, as it turned out, was actually completed before April 1, 2018). And it doesn’t apply to existing mortgages that are refinanced after December 15, 2017, provided the resulting debt doesn’t exceed the refinanced debt.
The elimination of interest deductions for home equity indebtedness, however, applies to existing debt. So, if you were previously deducting interest on up to $100,000 of home equity debt, that interest is no longer deductible. The same holds true for the $100,000 home equity portion of $1.1 million in mortgage debt. Note, however, that interest on a home equity loan used to substantially improve a qualified residence is deductible as acquisition indebtedness (subject to applicable limits).
Investment interest refers to interest on money used to purchase taxable investments (margin loans, for example). Like qualified residence interest, investment interest is an itemized deduction, which is lost if you no longer itemize.
Deductions of investment interest cannot exceed your net investment income, which generally includes interest income and ordinary dividend income, but not lower-taxed capital gains, qualified dividends or tax-free investment earnings. For many people, net investment income is now higher because the TCJA eliminated miscellaneous itemized deductions for such expenses.
Qualified student loan interest
Thankfully, the TCJA preserves the deduction for up to $2,500 in qualified student loan interest. This deduction is particularly valuable, because it’s an “above-the-line” deduction (that is, it’s deducted in calculating adjusted gross income) rather than an itemized deduction.
For 2019, the deduction is gradually phased out beginning at $70,000 in modified adjusted gross income (MAGI) ($140,000 for joint filers) and eliminated when MAGI reaches $85,000 ($170,000 for joint filers).
As it was pre-TCJA, personal interest — also known as “consumer” interest — isn’t deductible. Generally, personal interest is any interest other than 1) the types described above, 2) passive activity interest (such as interest related to rental properties), and 3) interest on deferred estate tax payments. Examples include interest on car loans or credit card debt.
Review your interest expenses
In light of the TCJA’s changes, it’s a good idea to review your interest expense and make changes, if appropriate, such as paying off home equity loans whose interest is no longer deductible. Contact your advisor for more information.
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