Interest expense is the cost of borrowing money. Money is borrowed by individuals for personal or investment purposes and by businesses to fund operations or grow the company.
From a U.S. federal tax perspective, taxpayers can separate interest expense into several baskets:
- Personal Interest
- Mortgage Interest
- Investment Interest
- Business Interest
It is essential that taxpayers accurately categorize interest expense because each has different tax treatments for U.S. federal tax purposes.
Personal Interest Expense
Personal interest expense is generally never tax-deductible. For example, on January 1, 2023, John borrowed $15,000 from his bank to buy a motorcycle. John signs a 5-year promissory note with an 8% interest rate, and his monthly payments are $304.15. Each payment made by John will include interest and principal. After the first year, the figures are as follows:
- Total cash paid: $3,649.80 (304.15 times 12 months)
- Total interest expense: $1,108.20
- Total principal payments: $2,541.60
- $3,649.80 = $1,108.20 + $2,541.60
John’s interest expense for the year ($1,108.20) is the cost of borrowing money from his bank. Since his motorcycle is a personal use asset, he cannot deduct the personal interest expense on his tax return.
Mortgage Interest Expense
Interest expense on personal use assets is generally not tax deductible, however, an exception is made for mortgage interest on residential property. A taxpayer’s principal residence is a personal use asset. Although the mortgage is a debt on a personal use asset, the interest expense is generally tax deductible as an itemized tax deduction on Schedule A (Itemized Deductions).
Interest deduction limits apply to mortgages of $750,000 or more. For debts incurred before December 16, 2017, a higher $1,000,000 limitation applies. Our YouTube channel has a video tutorial on calculating the mortgage interest deduction limit on Form 1040 Schedule A. The IRS Publication 936 has more information on these limitations.
Investment Interest Expense
Investment interest expense applies to debts borrowed to purchase investment assets. For U.S. tax purposes, it is generally deductible as an itemized tax deduction on Schedule A.
For example, if John Taxpayer has a brokerage account and trades stocks on margin, he will pay margin interest expense to his broker. John can deduct the margin interest as an itemized tax deduction.
However, the amount of deductible interest is limited to the taxpayer’s investment income. Taxpayers report this calculation on IRS Form 4952 (Investment Interest Expense Deduction). Visit our YouTube channel for a video tutorial on Form 4592.
Business Interest Expense
Interest expense incurred by a company engaged in an active trade or business is generally 100% deductible. However, some taxpayers have interest expense limitations, as reported on IRS Form 8990 (Limitation on Business Interest Expense Under Section 163(j)).