15.14 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 (15.8). Points paid on refinancing generally are not deductible (15.7).

Planning Reminder

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.

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With the exception of deductible points (15.8), 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.