CHAPTER 15
Interest Expenses

On Schedule A (Form 1040 or 1040-SR), you may deduct three types of interest charges:

Premiums paid in 2020 for qualified mortgage insurance on a principal or second residence are deductible as interest but the deduction will not be allowed after 2020 unless Congress extends the law authorizing the deduction (15.5).

Interest on personal loans (such as loans to buy autos and other personal items and credit card finance charges) is not deductible with the exception of qualifying student loan interest; see Chapter 33.

Interest on loans for business purposes is fully deductible on Schedule C. Interest on loans related to rental property is fully deductible from rental income on Schedule E. Whether interest is a business, investment, or a personal expense generally depends upon the use made of the money borrowed, not on the kind of property used to secure the loan. However, interest on a loan secured by a first or second home may be deductible as home equity mortgage interest regardless of the way you use the loan.

Interest on a loan used to finance an investment in a passive activity is subject to the limitations discussed in Chapter 10. However, if you rent out a second home that qualifies as a second residence, the portion of mortgage interest allocable to rental use is deductible as qualified mortgage interest and is not treated as a passive activity expense.

15.1 Deduction for Home Mortgage Interest

If you itemize deductions, you generally may deduct on Schedule A (Form 1040 or 1040-SR) interest on home acquisition debt that is secured by a first or second home (see two-residence limit, below). This includes interest on home equity debt that also qualifies as home acquisition debt. However, there are limits on the amount of acquisition debt that can support an interest deduction. Home acquisition debt is debt used to buy, construct, or substantially improve the residence that secures the loan (15.2).

For 2018 through 2025, the Tax Cuts and Jobs Act made two changes to the mortgage interest deduction rules: (1) the limit on home acquisition debt is lowered except for debt that is “grandfathered,” and (2) no deduction is allowed for interest on home equity debt that does not otherwise qualify as acquisition debt.

Mortgage interest is deductible on up to $750,000 ($375,000 if married filing separately) of home acquisition debt taken out after December 15, 2017. Acquisition debt incurred on or before December 15, 2017, is “grandfathered,” so the prior law limit of $1 million ($500,000 if married filing separately) still applies to these loans for purposes of deducting interest on your returns for 2018 through 2025.

If you refinance grandfathered debt (debt obtained before 12/16/17), the refinanced debt remains grandfathered to the extent of the loan balance at the time of refinancing; See 15.2.

Examples showing how to apply the grandfather rules and the $750,000 ($375,000) limit for non-grandfathered acquisition debt are in 15.2.

Although current law generally prohibits a deduction for interest on a home equity loan for 2018 through 2025, this does not mean that interest on a home equity loan or home equity line of credit is never deductible. As discussed in 15.3, if a home equity loan is used to buy, construct, or substantially improve a first or second residence that the loan is secured by, the loan falls within the definition of home acquisition debt, so if the applicable limit on acquisition debt has not been reached, the interest on the home equity loan falling within the limit can still be deducted. The Examples in 15.3 illustrate how the new law rules for home equity debt work, including how the grandfather rules apply to some home equity loans but not others.

law Law Alert

Limit on Home Acquisition Debt

The maximum amount of home acquisition debt on which mortgage interest may be deducted for 2018 through 2025 is $750,000 ($375,000 if married filing separately). This limit applies only to loans obtained after December 15, 2017. For loans obtained on or before December 15, 2017, the prior-law limit of $1 million ($500,000 if married filing separately) continues to apply.

Acquisition loan must be secured by residence. To deduct interest on a home acquisition debt (15.2) or a home equity loan that qualifies as home acquisition debt (15.3), the loan must be secured by your main home or a second home, and the home that secures the loan must be the home that you use the loan to buy, construct, or substantially improve. For the loan to be “secured,” it must be recorded or satisfy similar requirements under state law. For example, if a relative gives you a loan to help you purchase a home, the relative must take the legal steps required to record the loan with local authorities; otherwise, you may not deduct interest that you pay on the loan. The IRS held in a private ruling that interest paid by a homeowners’ association on a loan to rebuild the common area is not deductible by the individual homeowners where their residences are not pledged as collateral.

cau Caution

Mortgage Interest Reported on Form 1098

Banks and other lending institutions report mortgage interest payments of $600 or more to the IRS on Form 1098 or a similar statement. You should receive a copy of Form 1098 (or similar statement) for 2020 by February 1, 2021. The lender will report in Box 1 of Form 1098 the mortgage interest it received from you in 2020. Deductible points (15.7) paid on the purchase of a principal home are included in Box 6 of Form 1098. Mortgage insurance premiums (15.5) of $600 or more are shown in Box 5 of Form 1098.

Two-residence limit for qualifying mortgage debt. The rules for deducting interest on qualifying home acquisition debt or home equity debt apply to loans secured by your principal residence and one other residence. A residence may be a condominium or cooperative unit, houseboat, mobile home, or house trailer that has sleeping, cooking, and toilet facilities. If you own more than two houses, you decide which residence will be considered your second residence. You do not have to live in the second residence to designate it as a qualifying home. However, a home that you rent out during the year may be designated as a second residence only if your personal use exceeds the greater of 14 days or 10% of the rental days. In counting rental days, include days that the home is held out for rental or listed for resale. In counting days of personal use, use by close relatives generally qualifies as your personal use (9.6).

A married couple filing jointly may designate as a second residence a home owned by either spouse.

If a married couple files separately, each spouse may generally deduct interest on debt secured by one residence. However, both spouses may agree in writing to allow one of them to deduct the interest on a principal residence plus a designated second residence.

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No Deduction for Postponed Mortgage Interest

If your lender agreed to forbearance on your home mortgage, which means your payments were postponed, you cannot deduct the interest that would have been paid during this time. Only interest payments actually made are deductible.

Interest on debt secured by a residence other than your principal or second home may still be deductible, but only if you use the proceeds for investment or business purposes (15.11).

Mortgage interest paid on your principal residence with assistance from Hardest Hit Fund. An IRS safe harbor (Notice 2018-63, amplifying Notice 2017-40) allows you to claim a deduction for mortgage interest and for real estate taxes (16.4) even though tax-free assistance has been received from a State Housing Finance Agency (State HFA) using funds from the Treasury Department’s HFA Hardest Hit Fund. For 2018 through 2021 (at the end of which the safe harbor is scheduled to expire), Notice 2018-63 allows homeowners to first allocate home mortgage payments made during the year to mortgage interest, and then use any reasonable method to allocate the balance of payments to real property taxes, mortgage insurance premiums, home insurance premiums, and mortgage principal.

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Mortgage Interest on a Third Home

Interest on debt secured by a residence other than your principal or second home is not deductible as home mortgage interest, but an interest deduction may still be allowed if you use the proceeds for investment or business purposes (15.11).

Interest on mortgage credit certificates. Under special state and local programs, you may be able to obtain a “mortgage credit certificate” to finance the purchase of a principal residence or to borrow funds for certain home improvements. A nonrefundable tax credit for interest paid on the mortgage may be claimed. The credit is computed on Form 8396 and claimed on Schedule 3 ( Form 1040 or 1040-SR). The credit equals the interest paid multiplied by the certificate rate set by the governmental authority, but the maximum annual credit is $2,000. If you claim the credit, your home mortgage interest deduction is reduced by the amount of the current year credit claimed on Form 8396. If you buy a home using a qualifying mortgage credit certificate and sell that home within nine years, you may have to recapture part of the tax credit on Form 8828.

 

15.2 Home Acquisition Loans

A qualifying “home acquisition loan” is a loan used to buy, build, or substantially improve your principal residence or second home (See 15.1 for the two-residence limit), and that is secured by the home being bought, constructed, or substantially improved. To be considered a substantial improvement, an improvement must add to the value of the home or prolong its useful life. Repairs do not qualify. You may deduct the interest paid on all your home acquisition debt, provided the total debt does not exceed the limit as discussed in the next paragraph.

Limit on home acquisition debt. If you have home acquisition debt that you incurred before December 16, 2017, you may deduct the interest you pay on the entire amount so long as the total acquisition debt does not exceed $1 million ($500,000 if you are married filing separately). Such debts are “grandfathered” by the Tax Cuts and Jobs Act, and the pre-Act $1 million limit (or $500,000 if married filing separately) continues to apply to the grandfathered debt (15.1).

For home acquisition debt incurred after December 15, 2017, the debt ceiling for purposes of figuring mortgage interest deductions for 2018 through 2025 is $750,000 ($375,000 if married filing separately). However, two “grandfather” rules allow the prior-law loan limit of $1 million limit (or $500,000 if married filing separately) to apply to debt obtained after December 15, 2017:

  1. The first exception is a transition rule for acquisition debt taken out to buy a home under a binding written contract that was in effect before December 16, 2017, provided the home purchase closing was on or before April 1, 2018.
  2. The second grandfather exception applies if, after December 15, 2017, you refinance acquisition debt that was originally obtained by that date. The $1 million debt limit (or $500,000 if married filing separately) continues to apply to the loan balance on the date of refinancing; see Example 2 on the next page. This refinancing exception lasts until the end of the term of the original loan. If the original loan is not being amortized over its term, the refinancing exception lasts until the first refinancing term ends, but no more than 30 years from the date of that first refinancing.

law Law Alert

Higher Loan Limit on “Grandfathered” Loans

Interest is deductible on home acquisition loans obtained before December 16, 2017, of up to $1million ($500,000 if married filing separately). The prior-law $1 million (or $500,000) acquisition debt limit is “grandfathered”, allowing the interest on such loans, and on a refinancing of such loans to be deducted currently. Home acquisition debt obtained after December 15, 2017, other than a refinancing of grandfathered debt, is $750,000 ($375,000 if married filing separately). See 15.2 for details and Examples.

When you have grandfathered home acquisition debt from before December 16, 2017 (no more than $1 million, or $500,000 if married filing separately), and you take out new loans subject to the $750,000 limit ($375,000 if married filing separately), the grandfathered debt reduces the $750,000 (or $375,000) limit available for the new loans. In other words, interest is only deductible on the new debt to the extent that the grandfathered debt has not used up the entire $750,000 (or $375,000) limit.

Use IRS worksheets if debt limit exceeded. If your total debt exceeds the home acquisition debt limit (grandfathered limit or new law limit), you must use IRS worksheets included in Publication 936 to figure the amount of your deductible interest. You need to divide the debt limit by the average mortgage balance to get the deductible percentage of interest paid. Publication 936 provides options for figuring your average balance.

Unmarried co-owners. Unmarried co-owners do not have to allocate the applicable acquisition debt limit (see above) between them. For example, you and a co-owner (not your spouse) buy a principal residence in 2020 using a $500,000 home acquisition loan for which you are both liable and that is secured by the residence. On your individual returns, you may each deduct your share of the total interest paid on the $500,000 debt. If the loan were for more than $750,000, each of your deductions would be based on the $750,000 limit for home acquisition debt obtained after December 15, 2017; the allowable deduction must be figured using the IRS worksheets in Publication 936. Prior to a 2015 Ninth Circuit Appeals Court decision, the IRS had taken the position, and the Tax Court agreed, that unmarried co-owners had to allocate the debt limit between them (at that time the limit was $1.1 million, $1 million for acquisition debt and $100,000 for home equity debt). The Ninth Circuit disagreed and allowed each co-owner to deduct interest on the full debt limit and the IRS announced in 2016 that it would follow the Ninth Circuit opinion (2016-31 IRB 193; acquiescence to Voss v. Commissioner, 796 F.3d 1051 (9th Cir. 2015).

Family member may be treated as beneficial/equitable owner entitled to deduction. A taxpayer who is not a legal owner of the property on the deed and who has no legal obligation to make mortgage payments may be allowed a deduction for payments of mortgage interest if he or she can show a beneficial or equitable ownership interest in the residence. This requires a showing that the taxpayer has assumed the benefits and burdens of ownership. The Tax Court considers the following factors as evidence that the benefits and burdens of ownership have been assumed:

  1. The right to possess the property and enjoy its use, rents, or profits;
  2. A duty to maintain the property;
  3. Being responsible for insuring the property;
  4. Bearing the property’s risk of loss;
  5. Being obligated to pay the property’s taxes, assessments, or charges;
  6. Having the right to improve the property without the legal owner’s consent;
  7. Having the right to obtain legal title at any time by paying the balance of the purchase price.

court Court Decision

Family Financing of Residence

The Tax Court allowed a taxpayer to deduct mortgage interest payments on a loan that his brother obtained when the taxpayer’s poor credit rating prevented him from obtaining a mortgage loan. The taxpayer’s brother bought the house but allowed the taxpayer and his wife to live there on the condition that they make the mortgage payments directly to the bank.

The IRS disallowed the taxpayer’s deduction for the mortgage interest on the grounds that he was not liable for the mortgage debt; his brother was. However, the Tax Court allowed the deduction, holding that the taxpayer was the beneficial (equitable) owner of the home and that he was legally obligated to his brother to pay off the mortgage.

As discussed in 15.2, the Tax Court has taken a similar approach in other cases to allow a mortgage interest deduction to a family member who could show that he or she was the beneficial owner of the home.

In several cases, the Tax Court concluded that a family member who was not a legal owner had assumed the benefits and burdens of ownership and thus became an equitable owner who could deduct mortgage interest payments; see the Court Decision sidebar in this section for an example.

In another case, the Tax Court allowed an interest deduction to a son who moved in with his mother on her California ranch after her divorce. She was unable to pay the mortgage and property taxes, and he agreed to pay them in exchange for her oral agreement to give him an ownership interest in the property. In 2010, the son paid $35,880 in interest on the mortgage, which he deducted. In 2013, his name was added to the legal title of the property. The IRS disallowed the 2010 deduction on the grounds that the son was not a legal owner obligated to make the payments until 2013. The Tax Court, however, allowed the deduction. Under California law, it is presumed that the legal owner, here the mother, is the sole beneficial owner, but the son was able to overcome this presumption by testifying credibly that they had an agreement that indicated an intent contrary to what was reflected in the deed. Moreover, he assumed the benefits and burdens of ownership by paying the mortgage and property taxes, as well as the insurance, cable bill, maintenance costs, and property improvements. He also bore a substantial risk of loss for his payments. Based on all the facts and circumstances, the Tax Court concluded that the son was an equitable owner of the property in 2010, and thereby entitled to a deduction for his mortgage interest payments.

 

Was your debt incurred in buying, constructing, or substantially improving a qualifying first or second residence? In some cases, you may treat a loan as home acquisition debt even though you do not actually use the loan proceeds to buy, build, or substantially improve the home. For example, if you buy a home for cash and within 90 days you take out a mortgage secured by the home, the mortgage is treated as home acquisition debt to the extent it does not exceed the home’s cost; it does not matter how you use the mortgage loan proceeds.

When you build a home, construction expenses incurred before the loan may qualify as home acquisition debt for a 24-month period; See 15.4. Similarly, if substantial improvements to a home are begun but not completed before a loan is obtained, the loan will be treated as acquisition debt (assuming the debt is secured by the home) to the extent of improvement expenses made within 24 months before the loan. If the loan is obtained within 90 days after an improvement is completed, the loan is treated as acquisition debt (assuming the debt is secured by the home) to the extent of improvement expenses made within the period starting 24 months before completion of the improvement and ending on the date of the loan.

Interest on a mortgage to buy or build a home other than your principal residence or qualifying second home (15.1) is treated as nondeductible personal interest. If a nonqualifying home is rented out, the part of the mortgage interest that is allocable to the rental activity is treated as passive activity interest subject to the limitations discussed in Chapter 10; the interest allocable to your personal use is nondeductible personal interest.

Cooperatives. In the case of housing cooperatives, debt secured by stock as a tenant-stockholder is treated as secured by a residence. The cooperative should provide you with the proper amount of your deductible interest. If the stock cannot be used to secure the debt because of restrictions under local law or the cooperative agreement, the debt is still considered to be secured by the stock if the loan was used to buy the stock. For further details on allocation rules, see IRS Publication 936.

Mortgage interest paid after house destroyed. If your principal residence or second home (15.1) is destroyed and the land is sold within a reasonable period of time following the destruction, the IRS treats the property as a residence for purposes of deducting interest payments on the mortgage during the period between the destruction of the residence and the sale of the land. In one case, the IRS allowed the interest deduction where a sale of land took place 26 months after the destruction of a home by a tornado.

If the destroyed residence is reconstructed and reoccupied within a reasonable period of time following the destruction, the property will continue to be treated as a residence during that period, and the interest payments on the mortgage on the property will be deductible. The IRS allowed an interest deduction where reconstruction began 18 months after, and was completed 34 months after, destruction of the home.

15.3 Home Equity Loans

Interest paid on home equity debt may be deducted as home mortgage interest for 2018 through 2025 only if the loan otherwise qualifies as home acquisition debt. If the debt is “only” home equity debt, a mortgage interest deduction is not allowed.

As discussed in 15.2, home acquisition debt is debt that is secured by your principal residence or second home and used to buy, build, or substantially improve that residence. If a home acquisition loan was taken out before December 16, 2017, the loan is treated as “grandfathered” debt subject to a loan limit of $1 million ($500,000 if married filing separately). If the loan was taken out after December 15, 2017, and it is not used to refinance a grandfathered debt, it is subject to an acquisition debt limit of $750,000 ($375,000 if married filing separately).

It is the use of the loan proceeds that determines if the loan qualifies and not how the loan is labeled. If a home equity loan or home equity line of credit (HELOC) is used to renovate a room in your main home or build an addition to the home, or to buy a second residence, the loan qualifies as home acquisition debt, assuming the loan is secured by the residence (first or second home) that is improved or purchased. If home equity debt qualifies as acquisition debt and the limit on acquisition debt has not already been reached, interest on the home equity debt falling within the limit is deductible; see the Examples below.

However, if the loan is not used to buy, build, or substantially improve your principal residence or second home, the interest is not deductible (for 2018-2025) as home mortgage interest regardless of the amount of the loan, because the loan does not qualify as home acquisition debt. For example, if you take a home equity loan in 2021 and use it to pay credit card debt, student loans, college tuition, medical bills, or other personal expenses, none of your interest payments in 2021-2025 on the loan will be deductible. For 2017 and prior years, the rule was different: interest on home equity loans used for personal expenses was generally deductible up to a debt limit of $100,000 ($50,000 if married filing separately), but the limit could not exceed the excess of the fair market value of your principal residence and second home (if any) over the amount of acquisition debt. However, for 2018 through 2025, no deduction is allowed for home equity loans used to pay personal living expenses.

Loans used for investment or business purposes. The mortgage interest restrictions on home equity loans do not apply to loan proceeds used to buy or improve investment or business property. For example, if you use a home equity loan secured by your principal residence to buy investment securities, the interest deduction is figured on Form 4562 and claimed on Schedule A as investment interest (15.9), not as mortgage interest. If you use a mortgage secured by your home to buy rental real estate, the interest paid is a rental expense deductible on Schedule E (9.2). If you are self-employed and use the mortgage loan proceeds to buy property used in your business, the interest is deductible on Schedule C (40.6).

law Law Alert

Interest on Certain Home Equity Loans Is Deductible

Interest on a home equity loan or equity line of credit is deductible as home mortgage interest only if the loan is used to buy, build, or substantially improve a residence (first or second home) that secures the loan. Such loans qualify as home acquisition loans and the interest paid is deductible subject to the acquisition loan limits (15.2).

Interest on a home equity loan used to pay personal living expenses, such as a loan used to pay off credit cards or student debt, is not deductible.

See 15.3 for details and Examples.

 

15.4 Home Construction Loans

Interest on a home construction loan may be fully deductible for a period of up to 24 months while the home is under construction. For the 24-month period starting with the commencement of construction, the loan is considered home acquisition debt subject to the $1 million ceiling or the $750,000 ceiling, depending on when the loan was obtained (15.2), provided that the loan is secured by the lot on which construction is taking place and the home is a principal residence or second home when it is actually ready for occupancy. In one case, the Tax Court allowed an interest deduction under the 24-month construction period rule even though the home was never built; see Example 4 below.

According to the IRS, if construction begins before a loan is obtained, the loan is treated as acquisition debt to the extent of construction expenses within the 24-month period before the date of the loan. In determining the date of the loan for purposes of this 24-month rule, you can treat the date of a written loan application as the loan date, provided you receive the loan proceeds within 30 days after loan approval.

Interest incurred on the loan before construction begins is treated as nondeductible personal interest (see Example 1 in this section). If construction lasts more than 24 months, interest after the 24-month period also is treated as nondeductible personal interest.

Interest on loans taken out within 90 days after construction is completed may qualify for a full deduction. The loan is treated as acquisition debt to the extent of construction expenses within the last 24 months before the residence was completed, plus expenses through the date of the loan (see Example 2 below). For purposes of the 90-day rule, the loan proceeds generally are treated as received on the loan closing date. However, the date of a written loan application is treated as the loan date if the loan proceeds are actually received within 30 days after loan approval. If a loan application is made within the 90-day period and it is rejected, and a new application with another lender is made within a reasonable time after the rejection, a loan from the second lender will be considered timely even if more than 90 days have passed since the end of construction.

 

15.5 Mortgage Insurance Premiums and Other Payment Rules

Payments to the bank or lending institution holding your mortgage may include interest, principal payments, taxes, and insurance premiums. If you itemize deductions, you may deduct eligible home mortgage interest (15.2, 15.3), taxes (16.4), and, possibly, mortgage insurance premiums (see below).

law Law Alert

Deduction for Mortgage Insurance Premiums Expires at End of 2020

The law authorizing the deduction for mortgage insurance premiums is scheduled to expire at the end of 2020. See the e-Supplement at jklasser.com for an update on whether Congress extends the deduction.

In the year you sell your home, check your settlement papers for interest charged up to the date of sale; this amount is deductible.

Mortgage insurance premiums. The law that authorized a deduction for mortgage insurance premiums expired at the end of 2017, but in 2019, Congress retroactively extended the deduction to 2018 and allowed a deduction for qualified mortgage premiums paid in 2019 and 2020. For 2020 (or 2019), the deduction is claimed on Line 8d of Schedule A (Form 1040 or 1040-SR). If you paid qualifying premiums in 2018, you may file an amended return (Form 1040-X) for 2018 to claim the deduction (47.1).

To qualify for a deduction, the mortgage premiums must be paid for home acquisition debt (15.2) under an insurance contract issued after 2006. The mortgage insurance may be from certain private providers, the Federal Housing Administration, Department of Veterans Affairs, or the Rural Housing Service. If you paid $600 or more of qualified mortgage insurance premiums in 2020, your payments should be shown in Box 5 of Form 1098.

A deduction is subject to a phaseout rule. The deduction is phased out by 10% for every $1,000, or fraction of $1,000, of adjusted gross income (AGI) exceeding $100,000 or, if married filing separately, by 10% for every $500 of AGI over $50,000. The deduction is completely phased out if AGI exceeds $109,000, or $54,500 if married filing separately.

If in 2020 you prepaid premiums allocable to later years, you must allocate the premiums over the shorter of 84 months or the mortgage term and treat prepayments as paid over the allocation period, unless the mortgage insurance is from the Department of Veterans Affairs or the Rural Housing Service. If allocation is required, only the payment allocable to 2020 may be deducted on your 2020 return, assuming it is not disallowed under the phaseout rule. Payments allocable to 2021 and later years will be deductible only if Congress extends the deduction beyond 2020; see the e-Supplement at jklasser.com for a legislation update.

Mortgage interest paid on your principal residence with assistance from Hardest Hit Fund. An IRS safe harbor (Notice 2018-63, amplifying Notice 2017-40) allows you to claim a deduction for mortgage interest (15.1) and for real estate taxes (16.4) even though tax-free assistance has been received from a State Housing Finance Agency (State HFA) using funds from the Treasury Department’s HFA Hardest Hit Fund. See 15.1 for safe harbor details.

Interest on mortgage credit certificates. Under special state and local programs, you may be able to obtain a “mortgage credit certificate” to finance the purchase of a principal residence or to borrow funds for certain home improvements. A tax credit for interest paid on the mortgage may be claimed; See 15.1.

Prepayment penalty. A penalty for prepayment of a home mortgage is deductible as home mortgage interest provided the penalty is not for specific services provided by the mortgage holder.

Mortgage assistance payments. You may not deduct interest paid on your behalf under Section 235 of the National Housing Act.

fil Filing Tip

Joint Liability on Mortgage

If you do not personally receive a Form 1098 but a person (other than your spouse with whom you file a joint return) who is also liable for and paid interest on the mortgage received a Form 1098, you deduct your share of the interest and attach a statement to your Schedule A showing the name and address of the person who received the form. If you are the payer of record on a mortgage on which there are other borrowers entitled to a deduction for the interest shown on the Form 1098 you received, provide them with information on their share of the deductible amount.

The Tax Court has allowed a joint obligor to deduct his or her payment of another obligor’s share of the mortgage interest if the payment is made to avoid the loss of the property, and payment is made with his or her separate funds.

Delinquency charges for late payment. According to the IRS, a late payment charge is deductible as mortgage interest if it was not for a specific service provided by the mortgage holder. In one case, the Tax Court agreed with the IRS that delinquency charges imposed by a bank were not interest where they were a flat percentage of the installment due, regardless of how late payment was. The late charges were primarily imposed by the bank to recoup costs related to collection efforts, such as telephone calls, letters, and supervisory reviews. They were also intended to discourage untimely payments by imposing a penalty.

Graduated payment mortgages. Monthly payments are initially smaller than under the standard mortgage on the same amount of principal, but payments increase each year over the first five- or 10-year period and continue at the increased monthly amount for the balance of the mortgage term. As a cash-basis taxpayer, you deduct the amount of interest actually paid even though, during the early years of the mortgage, payments are less than the interest owed on the loan. The unpaid interest is added to the loan principal, and future interest is figured on the increased unpaid mortgage loan balance. The bank, in a year-end statement, will identify the amount of interest actually paid. (An accrual-basis taxpayer may deduct the accrued interest each year.)

Reverse mortgage loan. Homeowners who own their homes outright may in certain states cash in on their equity by taking a “reverse mortgage loan.” Typically, 80% of the value of the home is paid by a bank to a homeowner in a lump sum or in installments. Principal is due when the home is sold or when the homeowner dies; interest is added to the loan and is payable when the principal is paid. The IRS has ruled that an interest deduction may be claimed by a cash-basis home-owner only when the interest is paid, not when the interest is added to the outstanding loan balance. A deduction is subject to the limits for interest on home equity loans (15.3).

Redeemable ground rents. In a ground rent arrangement, you lease rather than buy the land on which your home is located. Ground rent is deductible as mortgage interest if: (1) the land you lease is for a term exceeding 15 years (including renewal periods) and is freely assignable; (2) you have a present or future right to end the lease and buy the entire interest; and (3) the lessor’s interest in the land is primarily a security interest. Payments to end the lease and buy the lessor’s interest are not deductible ground rents.

15.6 Interest on Refinanced Loans

When you refinance home acquisition debt (15.2) for the same amount as the remaining principal balance on the old loan, there is no change in the tax treatment of interest. In other words, if interest was fully deductible on the old loan, then it is fully deductible on the new loan.

As discussed in 15.2, if you took out home acquisition debt before December 16, 2017, and you refinance that debt for more than the existing balance, the refinanced debt is considered “grandfathered” acquisition debt to the extent of the loan balance at the time of refinancing, and as “grandfathered” debt, that amount is subject to the $1 million limit for acquisition debt. The refinanced amount in excess of the existing balance is considered acquisition debt only if it is used to buy, build, or substantially improve your first or second home (15.2), and interest on that debt is deductible for 2018 through 2025 only if the debt falls within the $750,000 limit for non-grandfathered loans incurred after December 15, 2017.

Interest paid on home acquisition loans in excess of the applicable ceiling (either $1 million or $750,000; (15.2)) is generally treated as nondeductible personal interest unless the proceeds are used for business or investment purposes (15.3, 15.11).

Points Paid on Refinancing

The IRS does not allow a current deduction for points on a refinanced mortgage. According to the IRS, the points must be deducted ratably over the loan period, unless part of the new loan is used for improvements to a principal residence. Thus, if you pay points of $2,400 when refinancing a 20-year loan on your principal residence, the IRS allows you to deduct only $10 a month, or $120 each full year.

A federal appeals court rejected the IRS allocation rule where points are paid on a long-term mortgage that replaces a short-term loan; see the Court Decision in this section (15.7).

If part of a refinancing is used for home improvements to a principal residence, the IRS allows a deduction for a portion of the points allocable to the home improvements.

court Court Decision

Current Deduction for Points on Refinancing

Huntsman replaced a three-year loan used to purchase his principal residence with a 30-year mortgage. He deducted $4,400 of points paid on the new mortgage. The IRS and the Tax Court held that the points had to be deducted over the 30-year loan term.

The Federal Appeals Court for the Eighth Circuit disagreed and allowed a full deduction in the year the points were paid. The first loan was temporary and merely a step in obtaining permanent financing for the purchase of the principal residence.

The IRS has announced that in areas outside of the Eighth Circuit, it will continue to disallow full deductions in the year of payment for points paid on refinancings. The Eighth Circuit includes only these states: Minnesota, Iowa, North and South Dakota, Nebraska, Missouri, and Arkansas. In these states, the IRS will not challenge deductions for points on refinancing agreements similar to Huntsman’s that replace short-term financing with long-term permanent financing.

In a later case, the Tax Court held that the Huntsman exception does not apply where a borrower refinances a long-term mortgage to take advantage of lower interest rates; the points must be deducted over the term of the new mortgage.

 

Mortgage ends early. If you are ratably deducting points on a refinanced loan and you refinance again with a different lender, or the mortgage ends early because you prepay it or the lender forecloses, you can deduct the remaining points in the year the mortgage ends (15.7).

15.7 “Points”

Lenders sometimes charge “points” in addition to the stated interest rate. The points increase the lender’s upfront fees, but in return borrowers generally are charged a lower interest rate over the loan term. Points are either treated as a type of prepaid interest (15.13) or as a nondeductible service fee, depending on what the charge covers. If the points qualify as interest, they are deductible over the term of the loan unless they are paid on the purchase or improvement of your principal residence, in which case they are deductible in the year they are paid, as discussed below. If you pay points on a loan to purchase or improve a second home, you must deduct the points ratably over the term of the loan.

Points are treated as interest if your payment is solely for your use of the money and is not for specific services performed by the lender that are separately charged. Whether a payment is called “points” or a “loan origination fee” does not affect its deductibility if it is actually a charge for the use of money. The purpose of the charge—that is, for the use of the money or the services rendered—will be controlling. For example, you may not deduct points that are fees for services, such as appraisal fees, preparation of a mortgage note or deed of trust, settlement fees, notary fees, abstract fees, commissions, and recording fees.

If you are selling property and you assume the buyer’s liability for points, do not deduct the payment as interest but include it as a selling expense that reduces the amount realized on the sale.

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Service Fees Are Not Deductible Points

You may not deduct as points amounts that are for specific lender services. To be deductible, points on the purchase of a principal residence must be prepaid interest for the use of the loan money.

Deduction for Points on Purchase or Improvement of Principal Residence

Points are generally treated as prepaid interest (15.13) that must be deducted over the period of the loan. However, there is an exception for points you pay on a loan to buy, build, or improve your principal residence. The points on such loans are deductible in the year paid if these tests are met: (1) the loan is secured by your principal residence; (2) the charging of points is an established business practice in the geographic area in which the loan is made; (3) the points charged do not exceed the points generally charged in the area; (4) the amount of points is computed as a percentage of the loan and specifically earmarked on the loan closing statement as “points,” “loan origination fees,” or “loan discount”; and (5) you pay the points directly to the lender; see “Points withheld from the principal,” below.

Points paid by seller are deductible by buyer. The seller’s payment is treated as an adjustment to the purchase price that the seller gives to you as the buyer and that you then turn over to the lender to pay off the points. You may fully deduct the points in the year paid if you meet the tests in the preceding paragraph. Otherwise, deduct them over the term of the loan. You must reduce your cost basis for the home by the seller-paid points.

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Amortize Points Starting in Second Year

A married couple purchased a principal residence and paid points late in the year. For the year of the purchase, their standard deduction exceeded their itemized deductions. The IRS ruled that claiming the standard deduction for the year the points are paid would not entirely forfeit the deduction for points. The points may be amortized starting in the second year. Assuming that they itemize deductions starting in the second year, the allocable portion of the points may be deducted each year over the remaining loan term.

Points withheld from the principal. Points withheld from the principal of a loan used to buy, build, or improve your principal residence are deductible as if you paid them directly to the lender if, at or before closing, you have made a down payment, escrow deposit, or earnest money payment that is at least equal to the amount of points withheld. These payments must have been from your own funds and not from funds that have been borrowed from the lender as part of the overall transaction.

Points on second home. If you pay points on a mortgage secured by a second home or a vacation home, the points are not fully deductible in the year of payment; you must claim the deduction ratably over the loan term.

Points paid on refinancing. The IRS does not allow a current deduction for points on a refinanced mortgage (15.6).

Deduct balance of points if mortgage ends early. If you are deducting points over the term of the loan because a full first-year deduction is not allowed, you are allowed to deduct the balance in the year the mortgage ends, such as when you prepay the loan, or the lender forecloses. If the mortgage ends early because you refinance the mortgage with a different lender, you may deduct the balance of the points. For example, if you refinanced your mortgage in 2006 and paid points, those points had to be amortized over the loan term (15.6). If in 2020 you refinance again with a different lender and pay points again, the balance of the points from the 2006 loan are deductible on your 2020 return, and the points on the new loan must be amortized over the loan term. If you refinanced with the same lender, the balance of the points from the 2006 loan must be deducted over the term of the new loan.

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Points Reported to the IRS

Points you paid in 2020 on the purchase of your principal residence will be reported to the IRS by the lender on Form 1098 if they meet the five tests for a deduction listed in 15.87. Seller-paid points are also included on Form 1098. Form 1098 is used by the IRS to check on the deduction you claim for points on Schedule A. Points paid on an improvement loan for your principal residence also are deductible if they meet the tests; they are not shown on Form 1098.

15.8 Cooperative and Condominium Apartments

Cooperative apartments. If you are a tenant-stockholder of a cooperative apartment, you may deduct your portion of:

  • Mortgage interest paid by the cooperative on its debts to buy the land, or buy, build or improve the housing complex, provided the apartment is your first or second home (15.1). This includes your pro rata share of the permanent financing expenses (points) of the cooperative on its mortgage covering the housing project.
  • Real estate taxes paid by the cooperative (16.6). However, if the cooperative does not own the land and building but merely leases them and is required to pay real estate taxes under the terms of the lease, you may not deduct your share of the tax payment.

In some localities, such as New York City, rent control rules allow tenants of a building converted to a cooperative to remain in their apartments even if they do not buy into the co-op. A holdover tenant may prevent some co-op purchasers from occupying an apartment. The IRS ruled that the fact that a holdover tenant stays in the apartment will not bar the owner from deducting his or her share of the co-op’s interest and taxes.

Condominiums. If you own an apartment in a condominium, you have a direct ownership interest in the property and are treated, for tax purposes, just as any other property owner. You may deduct your payments of real estate taxes and mortgage interest. You may also deduct taxes and interest paid on the mortgage debt of the project allocable to your share of the property. The deduction of interest from condominium ownership is also subject to the two-residence limit (15.1). If your condominium is used part of the time for rental purposes, you may deduct expenses of maintenance and repairs and claim depreciation deductions subject to certain limitations (9.7).

15.9 Investment Interest Limitations

Interest paid on margin accounts and debts to buy or carry other investments is deductible on Schedule A up to the amount of net investment income. If you do not have investment income such as interest, you may not deduct investment interest. Investment income for purposes of the deduction generally does not include net capital gains or qualified dividends, but you may elect to include them in order to increase your investment interest deduction. If you make the election, the elected amount will not be eligible for the favorable capital gain rates; see “Computing the Deduction” below. Investment interest in excess of net investment income may be carried forward and deducted from next year’s net investment income.

You compute the deduction for investment interest on Form 4952, which must be attached along with Schedule A ( Form 1040 or 1040-SR).

What is investment interest? It is all interest paid or accrued on debts incurred or continued to buy or carry investment property such as interest on securities in a margin account. However, interest on loans to buy tax-exempt securities is not deductible (15.10).

Investment interest does not include interest on qualifying home acquisition debt (15.2) or home equity debt (15.3), construction period interest that is capitalized (16.4), or interest related to a passive activity (10.8).

Investment property includes property producing portfolio income (interest, dividends, or royalties not realized in the ordinary course of business) under the passive activity rules discussed in Chapter 10, and property in activities that are not treated as passive activities, even if you do not materially participate, such as working interests in oil and gas wells.

cau Caution

Interest on Loans To Buy Market Discount Bonds and Treasury Bills

Limits apply to the deduction for interest on loans used to buy or carry market discount bonds (4.20) and Treasury bills (4.27).

Passive activity interest is not investment interest. Interest expenses incurred in a passive activity such as rental real estate (10.1), or a limited partnership or S corporation in which you do not materially participate (10.6), are taken into account on Form 8582 when figuring net passive income or loss. This includes interest incurred on loans used to finance your investment in a passive activity. Do not treat passive activity interest as investment interest on Form 4952.

However, interest expenses allocable to portfolio income (non–business activity interest, dividends, or royalties) from a limited partnership or S corporation are investment interest and not passive interest. The investment interest will be listed separately on Schedule K-1 received from the partnership or corporation.

Computing the Deduction

Deductible investment interest is limited to net investment income. Net investment income is the excess of investment income over investment expenses. The key terms investment income and investment expenses are defined below.

Investment income. Investment income is generally gross income from property held for investment, such as interest, dividends (but not qualified dividends unless you elect to include them; see next paragraph), annuities, and royalties. Income or expenses considered in figuring profit or loss of a passive activity (10.8) is not considered investment income or expenses. Property subject to a net lease is not treated as investment property, as it is within the passive activity rules.

Do you have net capital gain or qualified dividends? If you have net capital gain (net long-term capital gains exceeding net short-term losses) from the sale of investment property such as stocks or mutual fund shares, or capital gain distributions from mutual funds, such gains and distributions are not treated as investment income unless you specifically elect to include them in investment income on Form 4952. You may elect to include all or part of them. The same election rule applies to qualified dividends (4.1) that are subject to net capital gain tax rates. An election must be made on Form 4952 to include qualified dividends in investment income. If you make this election, you may not apply preferential capital gain rates (5.3) to the amount of the capital gains (and capital gain distributions) or qualified dividends treated as investment interest on Form 4952. If you make the election on Form 4952, the elected amount is subtracted from net capital gains when applying the capital gain tax rates on the IRS worksheets (5.3).

Investment expenses. If you have deductible expenses, other than interest, directly connected with the production of investment income, they reduce investment income on Form 4952; see the form instructions.

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Electing To Treat Long-Term Gains or Dividends as Investment Income

If you elect on Form 4952 to treat net capital gains (5.3) or qualified dividends (4.2) as investment income in order to increase your investment interest deduction, that amount is not eligible to be taxed at favorable capital gain rates (5.3).

Net investment income. Reducing investment income by investment expenses gives you net investment income. Your deduction for investment interest expenses is limited to this amount; any excess interest expense you had in 2020 may be carried over to 2021, as discussed below.

Where to enter the deduction on your return. The deduction figured on Form 4952 is generally entered on Schedule A (Form 1040 or 1040-SR) as investment interest. However, if the interest is attributable to royalties, you may have to enter the interest on Schedule E; follow the Form 4952 instructions. Furthermore, there is an additional complication if you have investment interest for an activity for which you are not “at risk”

(10.18). After figuring the investment interest deduction on Form 4952, you must enter the portion of the interest that is attributable to the at-risk activity on Form 6198. The amount carried over to Form 6198 is subtracted from the investment interest deduction claimed on Form 4952.

Carryover to 2021 and future years. Investment interest in excess of net investment income for 2020 may be carried forward to 2021 and future years until it can be claimed. On Form 4952, the carried-over amount is added to the current year investment interest and is deductible to the extent the total does not exceed net investment income.

 

15.10 Debts To Carry Tax-Exempt Obligations

When you borrow money in order to buy or carry tax-exempt bonds, you may not deduct any interest paid on your loan. Application of this disallowance rule is clear where there is actual evidence that loan proceeds were used to buy tax-exempts or that tax-exempts were used as collateral. But sometimes the relationship between a loan and the purchase of tax-exempts is less obvious, as where you hold tax-exempts and borrow to carry other securities or investments. IRS guidelines explain when a direct relationship between the debt and an investment in tax-exempts will be inferred so that no interest deduction is allowed. The IRS will not infer a direct relationship between a debt and an investment in tax-exempts in these cases:

  1. The investment in tax-exempts is not substantial. That is, it is not more than 2% of the adjusted basis of the investment portfolio and any assets held in an actively conducted business.
  2. The debt is incurred for a personal purpose. For example, an investor may take out a home mortgage instead of selling his tax-exempts and using the proceeds to finance the home purchase. Interest on the mortgage is deductible subject to certain limitations (15.1).
  3. The debt is incurred in connection with the active conduct of a business and does not exceed business needs. But if a person reasonably could have foreseen when the tax-exempts were purchased that he or she would have to borrow funds to meet ordinary and recurrent business needs, the interest expenses are not deductible.

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Tax-Exempt Income From Mutual Fund

You may not deduct interest on loans used to buy or carry tax-exempt securities. If you receive exempt-interest dividends from a mutual fund during the year, you may deduct interest on a loan used to buy or carry the mutual fund shares only to the extent that the proceeds can be allocated to taxable dividends you also receive.

The guidelines infer a direct relationship between the debt and an investment in tax-exempts in this type of case: An investor in tax-exempts has outstanding debts not directly related to personal expenses or to his or her business. The interest will be disallowed even if the debt appears to have been incurred to purchase other portfolio investments. Portfolio investments include transactions entered into for profit, including investments in real estate, that are not connected with the active conduct of a business; see the Example below.

 

15.11 Earmarking Use of Loan Proceeds For Investment or Business

The IRS has set down complex record keeping and allocation rules for claiming interest deductions on loans used for business or investment purposes, or for passive activities. The rules deal primarily with the use of loan proceeds for more than one purpose and the commingling of loan proceeds in an account with unborrowed funds. The thrust of the rules is to base deductibility of interest on the use of the borrowed funds. The allocation rules do not affect mortgage interest deductions on loans secured by a qualifying first or second home (15.1).

Keep separate accounts for business, personal, and investment borrowing. For example, if you borrow for investment purposes, keep the proceeds of the loan in a separate account and use the proceeds only for investment purposes. Do not use the funds to pay for personal expenses; interest is not deductible on personal loans other than qualifying student loans (Chapter 33). Furthermore, do not deposit loan proceeds in an account funded with unborrowed money, unless you intend to use the proceeds within 30 days of the deposit. By following these directions, you can identify your use of the proceeds with a specific expenditure, such as for investment, personal, or business purposes, and the interest on the loan may be treated as incurred for that purpose. The 30-day rule is discussed below.

The IRS treats undisbursed loan proceeds deposited in an account as investment property, even though the account does not bear interest. When proceeds are disbursed from the account, the use of the proceeds determines how interest is treated; see Examples 1 and 2 below.

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Keep Loans Separate

To safeguard your investment and business interest deductions, you must earmark and keep a record of your loans. You should avoid using loan proceeds to fund different types of expenditures.

30-day disbursement rule. If you deposit borrowed funds in an account with unborrowed funds, a special 30-day rule allows you to treat payments from the account as made from the loan proceeds. Where you make more than one disbursement from such an account, you may treat any expenses paid within 30 days before or after deposit of the loan proceeds as if made from the loan proceeds. Thus, you may allocate interest on the loan to that disbursement, even if earlier payments from the account have been made; see Example 3 below. If you make the disbursement after 30 days, the IRS requires you to allocate interest on the loan to the first disbursement; see Example 4 below. Furthermore, if an account includes only loan proceeds and interest earned on the proceeds, disbursements may be allocated first to the interest income and then to the loan proceeds.

Allocation period. Interest is allocated to an expenditure for the period beginning on the date the loan proceeds are used or treated as used and ending on the earlier of either the date the debt is repaid or the date it is reallocated.

Accrued interest is treated as a debt until it is paid, and any interest accruing on unpaid interest is allocated in the same manner as the unpaid interest is allocated. Compound interest accruing on such debt, other than compound interest accruing on interest that accrued before the beginning of the year, may be allocated between the original expenditure and any new expenditure from the same account on a straight-line basis. That is done by allocating an equal amount of such interest expense to each day during the taxable year. In addition, you may treat a year as twelve 30-day months for purposes of allocating interest on a straight-line basis.

Payments from a checking account. A disbursement from a checking account is treated as made at the time the check is written on the account, provided the check is delivered or mailed to the payee within a reasonable period after the writing of the check. You may treat checks written on the same day as written in any order. A check is presumed to be written on the date appearing on the check and to be delivered or mailed to the payee within a reasonable period thereafter. However, the presumption may not apply if the check does not clear within a reasonable period after the date appearing on the check.

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Using Borrowed Funds to Pay Investment or Business Interest

To get an interest deduction you must pay the interest; you may not claim a deduction by having the creditor add the interest to the debt. If you do not have funds to pay the interest, you may borrow money to pay the interest. The borrowed funds must be from a different creditor. The IRS disallows deductions where a debtor borrows from the same creditor to make interest payments on an earlier loan. The second loan is considered a device for getting an interest expense deduction without actually making payments. The Tax Court and several federal appeals courts have sided with the IRS.

Change in use of property. You must reallocate interest if you convert debt-financed property to a different use; for example, when you buy a business auto with an installment loan, interest paid on the auto is business interest, but if during the year you convert the auto to personal use, interest paid after the conversion is personal interest.

Order of repayment. If you used loan proceeds to repay several different kinds of debt, the debts being repaid are assumed to be repaid in the following order: (1) personal debt; (2) investment debt and passive activity debt other than active real estate debt; (3) debt from a real estate activity in which you actively participate; (4) former passive activity debt; and (5) business debt. See Example 5 below. Payments made on the same day may be treated as made in any order.

 

15.12 Year To Claim an Interest Deduction

As a cash-basis taxpayer, you deduct interest in the year of payment except for prepayments of interest (15.13). Giving a promissory note is not considered payment. Increasing the amount of a loan by interest owed, as with insurance loans, is also not considered payment and will not support a deduction. However, an accrual-basis taxpayer generally deducts interest in the year the interest accrues (40.3).

Here is how a cash-basis taxpayer treats interest in the following situations:

On a life insurance loan, where proceeds are used for a deductible (nonpersonal) purpose, you claim a deduction in the year in which the interest is paid. You may not claim a deduction when the insurance company adds the interest to your debt. You may not deduct your payment of interest on an insurance loan after you assign the policy.

On a margin account with a broker, interest is deductible in the year in which it is paid or your account is credited after the interest has been charged. But an interest charge to your account is not payment if you do not pay it in cash or the broker has not collected dividends, interest, or security sales proceeds that may be applied against the interest due. Note that the interest deduction on margin accounts is subject to investment interest limitations (15.9).

For partial payment of a loan used for a deductible (nonpersonal) purpose, interest is deductible in the year the payment is credited against interest due. When a loan has no provision for allocating payments between principal and income, the law presumes that a partial payment is applied first to interest and then to principal, unless you agree otherwise. Where the payment is in full settlement of the debt, the payment is applied first to principal, unless you agree otherwise. Where there is an involuntary payment, such as that following a foreclosure sale of collateral, sales proceeds are applied first to principal, unless you agree to the contrary. See also 15.11 for the effect of payments on the allocation of debt proceeds.

Note renewed. You may not deduct interest by merely giving a new note. You claim a deduction in the year the renewed note is paid. The giving of a new note or increasing the amount due is not payment. The same is true when past due interest is deducted from the proceeds of a new loan; this is not a payment of the interest.

15.13 Prepaid Interest

If you prepay interest on a loan used for investment or business purposes you may not deduct interest allocable to any period falling in a later taxable year. The prepaid interest must be deducted over the period of the loan, whether you are a cash-basis or accrual-basis taxpayer.

Points paid on the purchase of a principal residence are generally fully deductible in the year paid (15.7). Points paid on refinancing generally are not deductible (15.6). With the exception of deductible points (15.7), prepayments of mortgage interest are not deductible; interest must be spread to the years to which it applies. You can only deduct the interest that qualifies as home mortgage interest (15.1) for that particular year.

Treatment of interest included in a level payment schedule. Where payments of principal and interest are equal, a large amount of interest allocated to the payments made in early years of a loan will generally not be considered prepaid interest. However, if the loan calls for a variable interest rate, the IRS may treat interest payments as consisting partly of interest, computed under an average level effective rate, and partly of prepaid interest allocable to later years of the loan. An interest rate that varies with the “prime rate” does not necessarily indicate a prepaid interest element.

When you borrow money for a deductible purpose and give a note to the lender, the amount of your loan proceeds may be less than the face value of the note. The difference between the proceeds and the face amount is interest discount. For loans that do not fall within the OID rules (4.18), such as loans of a year or less, interest is deductible in the year of payment if you are on the cash basis. If you use the accrual basis, the interest is deductible as it accrues. For loans that fall within OID rules, your lender should provide a statement showing the interest element and the tax treatment of the interest.

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Business or Investment Loans

If you prepay business or investment loan interest, you must spread the interest deduction over the period of the loan. In the year of payment, you may deduct only the interest allocable to that year.