Limits on Deductions for Investment and Personal Interest

Limits on Deductions for Investment and Personal Interest

Investment Interest

Investment interest generally defined as interest used to buy or carry investment property-is deductible by noncorporate taxpayers only to the extent of net investment income.  Investment income includes income such as dividends, interest, and certain gain on the sale of investment property but, for purposes of the investment interest deduction, generally does not include net capital gain from disposing of investment property (including capital gain distributions from mutual funds) or qualified dividend income.  Net capital gain is the excess of net long-term capital gain for the year over the net short-term capital loss for the year.  Qualified dividend income is income from dividends that qualify to be taxed at the net capital gain tax rates.  However, a taxpayer can choose to include part or all of net capital gain and qualified dividend income in investment income.

Investment interest not allowed as a deduction for a tax year because of the investment interest limit is treated as interest paid or accrued in the following year and may eventually become deductible, either in the following tax year or in some later year.

Election to Include Net Capital Gain and Qualified Dividend Income in Investment Income

A taxpayer may elect to include all or part of his net capital gain and qualified dividend income in investment income.  However, any amount that the taxpayer elects to include in investment income does not qualify for the favorable tax rates that apply to net capital gain and qualified dividend income.  That is, net capital gain and qualified dividend income is reduced (but not below zero) by the amount the taxpayer elects to take into account as investment income to permit investment interest deductions.

Personal interest

Personal interest is not deductible.  This includes all interest except (1) interest connected with a trade or business, (2) investment interest, (3) passive activity interest, (4) qualified residence interest, (5) interest on qualifying higher-education loans, and (6) otherwise deductible interest on deferred estate tax payments.

Interest May Also be Subject to Passive Activity Loss Rules

The passive activity loss and investment interest rules dovetail in such a way that any interest, other than personal interest, qualified residence interest, estate tax interest, or interest relating to a trade or business in which the taxpayer materially participates, is subject to one of the two rules.  The application of the investment interest limitation is described above.  Interest that relates to a passive activity is subject to the passive activity rules.

Qualified Residence Interest

Qualified residence interest (QRI) is deductible.  QRI is interest on acquisition debt with the respect to any qualified residence of the taxpayer.  Acquisition indebtedness is debt that is incurred in acquiring, constructing or substantially improving the taxpayer’s qualified residence (or adjoining land) and is secured by that qualified residence.  A qualified residence is a taxpayer’s principal residence and/or any other residence (second residence) the taxpayer properly elects to treat as qualified for the tax year.  If the taxpayer has a principal residence and two or more other residences, he can choose each year which of the other homes qualifies as his second residence.

Under the Tax Cuts and Jobs Act (TCJA), for tax years beginning after December 31, 2017, and before January 1, 2026, the maximum amount that is treated as acquisition debt is $750,000 ($375,000 for a married taxpayer filing separately).  The $1 million, pre-TCJA limit applies to acquisition debt incurred before December 15, 2017, and to debt arising from refinancing pre-December 15, 2017 acquisition debt, to the extent the debt resulting from the refinancing does not exceed the original debt amount.  Thus, taxpayers can refinance up to $1 million of pre-December 15, 2017 acquisition debt, and that refinanced debt amount will not be subject to the reduced limitation.

For tax years beginning after December 31, 2017, and before January 1, 2026, taxpayers may not claim a deduction for interest on home equity debt.  However, IRS has clarified that for those years, the fact that a loan is labelled a home equity loan, home equity line of credit or second mortgage does not prevent the loan from being acquisition debt, if the loan is used to buy, build or substantially improve the taxpayer’s home that secures the loan-to the extent the dollar limitation on acquisition debt is not exceeded.

Tools & Resources

Top of the News

Sign-up for our newsletters

Subscribe to RSS