Chapter 15
Itemized Deduction for Interest Expenses

On Schedule A of Form 1040, you may deduct three types of interest charges:

• Home mortgage interest, which includes interest on qualifying home acquisition loans (15.2) and home equity loans (15.3)
• Points (15.8)
• Investment interest (15.10), but only up to the amount of net investment income (15.10).

Premiums paid in 2017 for qualified mortgage insurance on a principal or second residence will not be deductible as interest, unless Congress extends the law authorizing the deduction (15.6).

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.

Your deduction for home mortgage interest and points (but not investment interest) is subject to the reduction of itemized deductions if your adjusted gross income exceeds the annual threshold for your filing status (13.7).

15.1 Home Mortgage Interest

You generally may deduct on Schedule A (Form 1040) qualifying mortgage interest on up to two residences (see two-residence limit, below).

Interest deductions for home acquisition debt and home equity debt may be limited, depending on when you took out the mortgage, the amount of the debt, and how you use the loan proceeds.

$1 million acquisition debt and $100,000 home equity debt limits generally apply. A loan taken out after October 13, 1987, that is used to buy, construct, or improve a first or second home is called a home acquisition loan, and up to $1 million of such debt qualifies for a mortgage interest deduction, $500,000 if married filing separately (15.2). Loans used for any other purpose are called home equity loans by the tax law, and up to $100,000 of such debt may qualify for an interest deduction; the home equity limit is $50,000 for married persons filing separately (15.3).

Home acquisition loans are further discussed in 15.2. Home equity loans are discussed in 15.3.

Loan must be secured by residence. To deduct interest on a home acquisition (15.2) or home equity loan (15.3), the loan must be secured by your main home or a second home. 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, in a private ruling, held 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.

Mortgage loan obtained before October 14, 1987. You may deduct all of the interest on a loan secured by a first or second home if the loan was obtained before October 14, 1987. Technically, such loans are considered home acquisition debt, but they are treated as “grandfathered debt,” exempt from the $1 million loan limit ($500,000 for married persons filing separately).

However, the amount of your pre–October 14, 1987, loan reduces the $1 million (or $500,000) limit on home acquisition debt after October 13, 1987 (15.2). It also reduces the fair market value limit for home equity debt (15.3). If you refinance your loan, see 15.7.

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. Interest on debt secured by the second residence is deductible under the rules for acquisition debt (15.2) or home equity debt (15.3).

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.

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 (15.12).

Mortgage interest paid on your principal residence with assistance from Hardest Hit Fund. An IRS safe harbor (Notice 2017-40) allows you to claim a deduction for mortgage interest although 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. Assuming you otherwise qualify for a deduction of the mortgage interest on your loan, the safe harbor allows you to deduct all the payments you actually made to the mortgage servicer or to the State HFA in 2017, so long as it does not exceed the amounts shown on Form 1098 (“Mortgage Interest Statement”) for interest received (in Box 1) plus mortgage insurance premiums (in Box 5), assuming the deduction for mortgage premiums is extended to 2017 (15.6). The same rule allows a deduction for real estate taxes, which may be shown in Box 11 of Form 1098; see 16.4.

Under Notice 2017-40 the IRS safe harbor is scheduled to apply through 2021.

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. The credit is computed on Form 8396 and claimed on Line 54 of Form 1040 (“Other credits”). 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, provided the debt is secured by that same residence. Interest paid on such home acquisition loans is fully deductible if the total debt does not exceed $1,000,000, or $500,000 if you are married filing separately. See 15.1 for the two-residence limit.

The $1,000,000 (or $500,000) limit applies to acquisition loans taken out after October 13, 1987. If you incurred substantial loans before October 14, 1987, and plan to purchase a new home, your deduction for the mortgage for the new home may be limited. The $1 million limit for acquisition debt after October 13, 1987, is reduced by the amount of outstanding pre–October 14, 1987, debt. Although interest on a pre–October 14, 1987, debt is generally fully deductible regardless of the size of the loan, refinancing a pre–October 14, 1987, debt for more than the existing balance subjects the excess to the $1 million ceiling (15.7).

Loan limit for buying new home may be increased from $1 million to $1.1 million. The maximum home acquisition debt limit is $1,000,000, or $500,000 if you are married filing separately. However, there can be “home equity debt” on the initial purchase of a home, thereby increasing the allowable debt limit. Up to $100,000 of debt ($50,000 if married filing separately) in excess of the $1,000,000 (or $500,000) acquisition debt limit may qualify as home equity debt (15.3), which allows interest to be deducted on debt up to $1.1 million ($550,000 if married filing separately).

Home equity debt is defined as debt other than acquisition debt that is secured by the residence (principal residence or second home) and which does not exceed the fair market value of the residence minus the acquisition debt. For example, assume that you buy a new principal residence for $1.5 million, using $300,000 cash and a $1,200,000 mortgage loan secured by the residence. The first $1,000,000 of the debt is home acquisition debt (assuming you do not file as married filing separately). Of the remaining $200,000 debt, $100,000 qualifies as home equity debt, as it is less than the $500,000 excess of the fair market value ($1.5 million) over the acquisition debt ($1 million). Therefore, interest is deductible on debt of $1,100,000 ($1 million acquisition debt and $100,000 home equity debt).

Use IRS worksheets if debt limit exceeded. If your total debt exceeds the $1.1 million debt limit (or $550,000 if married filing separately), 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. The IRS no longer takes the position that unmarried co-owners must allocate the $1.1 million debt limit between them. In 2012 the IRS argued, and the Tax Court agreed, that the $1.1 million limit on debt secured by a first and/or second home must be allocated among the unmarried co-owners, but on appeal, the Ninth Circuit in 2015 allowed each co-owner to deduct interest on acquisition debt of up to $1 million plus home equity debt of up to $100,000.

The IRS announced in 2016 that it would follow the Ninth Circuit opinion; see the discussion of these court decisions in the Example below.

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.

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 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 or make improvements, expenses incurred before the loan may qualify as home acquisition debt; see 15.4 for construction loans and 15.5 for improvement loans.

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.

Line-of-credit mortgages. If you had a line-of-credit mortgage on your home on October 13, 1987, and you borrowed additional amounts on this line of credit after that date, the additional borrowed amounts are treated as a mortgage taken out after October 13, 1987. If the newly borrowed amounts are used to buy, build, or improve your first or second home, they are treated as home acquisition debt subject to the $1 million or $500,000 limit. If used for any other purpose, the amounts are subject to the home equity debt rules (15.3).

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

Mortgages that are not used to buy, build or improve your principal residence and/or second home (these are acquisition debt; see 15.2), are considered home equity debt. Interest you pay on home equity debt of up to $100,000 ($50,000 if married filing separately) is generally deductible, but the debt limit may be smaller in some cases depending on the value of the residence and the amount of acquisition debt; see below. In addition, as discussed in 15.2, debt you incurred to buy, build or improve your home may also qualify as home equity debt to the extent that such debt exceeds the $1 million acquisition debt limit ($500,000 if married filing separately).

The limit on home equity debt secured by your first and second home (15.1) is the lesser of:

1. $100,000, or $50,000 if married filing separately, or
2. The fair market value of your principal residence and second home (15.1), reduced by the amount of acquisition debt (15.2) and by any “grandfathered” (pre–October 14, 1987) mortgages (15.1). According to the IRS, fair market value, acquisition debt, and grandfathered debt are determined on the date that the last debt was secured by the home.

If you have a second home as well as a principal residence, the above limitation under (1) and (2) applies to the total debt for both homes. Interest on a qualifying home equity loan is deductible regardless of the way you spend the proceeds, unless it is used to buy tax-exempt obligations (15.11).

On loans exceeding the home equity debt limit, interest may be deductible if the proceeds are used for investment or business purposes. Otherwise, interest on the excess is nondeductible personal interest.

A loan may qualify partially as acquisition debt and partially as home equity debt where part of it is used to refinance an existing acquisition debt. The refinanced amount is still considered acquisition debt. Debt in excess of the refinanced amount is either home equity debt subject to the $100,000 ceiling or home acquisition debt subject to the $1 million ceiling, depending on the way the proceeds are used (15.7).

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 acquisition debt subject to the $1 million ceiling (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 Home Improvement Loans

Loans used for substantial home improvements are treated as home acquisition debt subject to the $1 million debt ceiling (15.2). Include only the cost of home improvements that must be added to the basis of the property because they add to the value of the home or prolong useful life. Repair costs are not considered.

If substantial improvements to a home are begun but not completed before a loan is incurred, 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 incurred 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.

15.6 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. You may deduct eligible home mortgage interest (15.2, 15.3), taxes (16.4), and, possibly, mortgage insurance premiums (see below).

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 2016, and Congress had not extended it to 2017 when this book was completed. If the law is not extended, no deduction will be allowed for any mortgage insurance premiums paid in 2017. Also, since the IRS generally requires prepayments of premiums to be allocated over the shorter of 84 months or the mortgage term and treats prepayments as paid over the allocation period (unless the mortgage insurance is from the Department of Veterans Affairs or the Rural Housing Service), no deduction will be allowed for a pre-2017 payment that is allocable to 2017 if Congress does not extend the law.

If the law is extended, a deduction for qualified mortgage insurance premiums (taking into account the prepayment/allocation rule) will be deductible as home mortgage interest for 2017 as long as it is not disallowed under the 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 excceds $109,000, or $54,500 if married filing separately. See the e-Supplement at jklasser.com for a legislation update.

Mortgage credit. If you qualify for the special tax credit for interest on qualified home mortgage certificates, you only deduct interest in excess of the allowable credit (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.

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.

15.7 Interest on Refinanced Loans

When you refinance a mortgage on a first or second home (15.1) 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.

If you refinance a home mortgage for more than the existing balance, the deductibility of interest on the excess amount depends upon how you use the funds and the amount of refinancing. If the excess amount is used to buy, build, or substantially improve your first or second home, then it is considered home acquisition debt (15.2). If the excess plus all other home acquisition loans does not exceed $1 million ($500,000 if married filing separately), the interest is fully deductible. If the excess is used for any other purpose, such as to pay off credit card debt or to finance a child’s education, the excess is considered home equity debt (15.3). If the excess plus all other home equity loans does not exceed $100,000 ($50,000 if married filing separately), the interest is fully deductible. If the refinanced loan is partly home acquisition debt and partly home equity debt, the overall limit of $1.1 million applies ($1 million home acquisition debt and $100,000 home equity debt) or, if married filing separately, $550,000 ($500,000 home acquisition debt and $50,000 home equity debt).

Interest paid on loans in excess of home acquisition and home equity debt ceilings is generally treated as nondeductible personal interest unless the proceeds are used for business or investment purposes (15.12).

Pre–October 14, 1987 loans. Refinanced pre–October 14, 1987 loans are not subject to the $1 million home acquisition and $100,000 home equity debt ceilings during the period of the original loan term. However, after the end of the loan term, the ceilings apply to the refinanced amount as explained above. Furthermore, where a refinanced pre–October 14, 1987 debt exceeds the remaining principal balance, the excess is also subject to the $1 million home acquisition and $100,000 home equity debt ceilings.

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 home improvements. 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.

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 (15.8).

15.8 “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 (15.14) 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.

Deduction for Points on Purchase or Improvement of Principal Residence

Points are generally treated as prepaid interest (15.14) 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.

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 (15.7).

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 (15.7). If in 2017 you refinance again with a different lender and pay points again, the balance of the points from the 2006 loan are deductible on your 2017 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.

15.9 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).

15.10 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 to Form 1040. Deductible investment interest is not subject to the reduction of overall itemized deductions for higher-income taxpayers (13.7).

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 (15.11).

Investment interest does not include interest on qualifying home acquisition debt (15.2) or home equity debt (15.3), production 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.

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, other than qualified dividends, 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 gains? If you have net capital gains (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 net 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. There are expenses, other than interest, directly connected with the production of investment income. However, for purposes of determining net investment income, only those investment expenses (other than interest) allowable after figuring the 2% floor for miscellaneous itemized deductions (19.1) are taken into account. The 2% floor will bar a deduction for some of the miscellaneous itemized deductions. For purposes of this net investment income computation, assume that miscellaneous itemized deductions other than investment expenses are disallowed first.

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 2017 may be carried over to 2018, as discussed below.

Where to enter the deduction on your return. The deduction figured on Form 4952 is generally entered on Schedule A 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 2018 and future years. Investment interest in excess of net investment income for 2017 may be carried forward to 2018 and future years until it can be claimed. A carryover will be added to the current year investment interest and be deductible to the extent the total does not exceed net investment income.

15.11 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.

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.

15.12 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.

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.

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.

15.13 Year To Claim an Interest Deduction

As a cash-basis taxpayer, you deduct interest in the year of payment except for prepayments of interest (15.14). 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 (15.10).

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 15.12 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.

15.14 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).

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.