Limits on Deductions for Investment and Personal Interest

Limits on Deductions for Investment and Personal Interest

The deductibility of investment and personal interest is limited.

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, the 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 maximum tax rates that apply to net capital gain and qualified dividend income.  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.  (In deciding whether to make the special election, taxpayers whose marginal rate is 25% or higher should compare the relative tax benefits of:

  • postponing the interest deduction to a later year, or
  • giving up the benefit of the maximum capital gain and qualified dividend income rate ceilings.

Their calculations should take into account the time value of money, the length of the deferral and the taxpayer’s top tax brackets for 2010 and for the year that the investment interest is likely to be deducted).

Personal Interest

Personal interest is not deductible.  This includes all interest except:

  • interest connected with a trade or business (but not interest paid on a tax deficiency arising from an unincorporated business),
  • investment interest,
  • passive activity interest,
  • qualified residence interest,
  • interest on qualifying higher-education loans, and
  • otherwise deductible interest on deferred estate tax payments.

Passive Activity Loss Rules

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

One kind of interest that remains deductible is qualified residence interest.  This term includes interest on debt secured by the taxpayer’s principal residence and one other qualified residence (including a trailer or houseboat).  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.

Qualified residence interest includes acquisition debt and home equity debt with respect to a taxpayer’s qualified residence.  The maximum amount of acquisition debt is $1 million.  Home equity debt cannot exceed $100,000 (or, if less, taxpayer’s equity in the home).  Under a grandfather provision, pre-October 14, 1987 mortgage debt (regardless of amount) is treated as acquisition debt.

Acquisition debt is debt that is incurred in acquiring, constructing or substantially improving the principal or second qualified residence of the taxpayer and which is secured by the residence.  If the debt to acquire, construct or substantially improve a principal and second residence exceeds $1 million, then only the interest on a total principal amount of $1 million is deductible as interest on acquisition debt.

You cannot deduct the interest for acquisition debt greater than $1 million ($500,000 for married individuals filing separately).  So, for example, if you were to buy a $2 million house with a $1.5 million mortgage, only the interest that you pay on the first $1 million in debt will be deductible.  The rest will be considered personal interest and not deductible.

Note also that the $1 million ceiling on deductible home mortgage debt includes both your primary residence and your second home combined.

Acquisition indebtedness is defined by code section 163(h)(3) as any indebtedness which is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence.  In other words if you borrowed $500,000 from the bank and secured this loan with your primary residence and further used the $500,000 to acquire a vacation home in Wisconsin, a literal reading of the code would conclude that the interest expense on this $500,000 loan would be non-deductible personal interest and this is because the Wisconsin residence does not secure such debt.  The interest on this same loan would be fully deductible simply by securing the loan by the Wisconsin residence.

We have seen many clients borrowing on their principal residence in order to acquire a second home in the last few years.  In order to be able to deduct this interest expense you must make sure that the debt is secured by the second home.  While this may seem unnecessary, we have reached our conclusions after receiving second opinions on this issue from a law firm as well as directly from the IRS.

A residence under construction may be treated as a qualified residence for a period of up to 24 months, but only if it becomes a qualified residence as of the time it is ready for occupancy.  The 24-month period referred to above may begin on or after the date construction began.

X owns a residential lot.  On April 20 of year 1, X obtains a mortgage loan secured by the lot and any property to be constructed on the lot.  He uses the proceeds of the loan to finance the construction of a vacation home on the lot.  Construction commences on August 9 of year 1.  The vacation home is ready for occupancy on November 9 of year 3, and qualified as X’s second residence at that time.  Under these circumstances, X may treat the vacation home as a second residence for any 24-month period during which it was under construction.  This 24-month period may commence on or after the date construction began (August 9 of year 1).  If X chooses to begin this 24-month on August 9 of year 1, the period ends on August 8 of year 3.  Whether the vacation home is a qualified residence for the period August 9 – November 8 of year 3 is determined without regard to the “under construction” rules.

If you are planning to refinance your mortgage, special rules apply.  If the old mortgage that you are refinancing is home acquisition debt, your new mortgage will also be home acquisition debt, up to the principal balance of the old mortgage just before it was refinanced.  The interest on this portion of the new mortgage will be deductible.  Any debt in excess of this limit will not be home acquisition debt.  In other words, a taxpayer who refinances cannot take down additional cash and have it count as acquisition indebtedness.  Acquisition indebtedness may be refinanced to take advantage of lower rates or more favorable terms.  As long as there is no additional amount of indebtedness the new debt is also treated as acquisition indebtedness.  In general, points that you pay to refinance your home are not fully deductible in the year that you paid them.  Instead, you can deduct a portion of these points each year over the life of the loan.

Home Equity Debt

Home equity debt is debt (other than acquisition debt) secured by the taxpayer’s principal or second residence.  Interest on home equity debt is deductible even if the proceeds are used for personal purposes.

Tracing of Interest

Temporary regs on allocating interest expense for purposes of the limitations on passive activity losses, investment and personal interest employ a system of tracing disbursements of debt proceeds to specific expenditures.  This generally means that the allocation of interest depends on how the debt proceeds are used.  An exception to this rule applies to qualified residence interest, the allocation of which is governed by the security (i.e., the residence) given for the debt.  Taxpayers can take advantage of these rules by using loan proceeds for deductible purposes, or by using home equity debt as the source of personal expenditures.

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