Interest Payment Deductions
When it comes to loans and interest payments, there are some common misconceptions about the deductibility of the interest payments for tax purposes. Some interest is deductible in full, some is subject to limitation, and other types of interest are completely non-deductible. Throughout this article, we will explore different types of interest and how/when it can be used as a deduction against your income.
Interest Expense Rules
Generally speaking, an interest payment’s deductibility is dependent on the loan itself and what the proceeds were used for. Below are some of the most common types of interest expenses and how they are treated for tax purposes.
Mortgage Interest
The most common type of interest expense is the interest paid on a mortgage loan. If a loan is secured by your main home or second home, the interest payments are deductible as an itemized deduction and reported on Schedule A of your tax return. The amount of interest paid is reported to you on Form 1098. Please note that the outstanding mortgage balance reported on Box 2 of the form, is the balance as of January 1 of the current tax year. You may also need to know the balance as of December 31st to determine your deductible mortgage interest, as the deductible portion is based on the average loan balance during the year.
However, this mortgage interest deduction is subject to certain limitations.
If the loan originated before December 15, 2017, your interest deduction is limited to the interest paid on the first $1M of loan balance, while the remaining interest paid is non-deductible.
For loans originating in 2018 or later, the loan limit decreases to $750,000. These are the rules applicable for your federal return, which may or may not apply to your resident state. For example, CA residents can deduct interest on up to $1.1M of outstanding mortgage balance. Therefore, it is not uncommon for there to be an additional interest deduction for CA as compared to federal. We have created a helpful tool for estimating your deductible mortgage interest:
These above limitations are applicable to one’s primary residence as well as second home. However, in the case of a rental property, the mortgage interest deduction is deductible in full against the property’s rental income, reported on Schedule E of your tax return. This is regardless of the outstanding loan balance. For those who rent a portion of their home, the interest deduction can be bifurcated between personal use (itemized deduction) and rental use (rental deduction).
Home Equity Loan (HELOC) Interest
In order for a loan to be deductible as mortgage interest, a few specific criteria must be met:
The loan must be secured by the home.
The loan must qualify as home acquisition debt, meaning the proceeds were used to buy, build, or substantially improve the home.
If you were to take out a home equity loan and use the proceeds for any reason outside of the above, it would not be deductible as mortgage interest. If the proceeds are used to substantially improve the home, the same mortgage limitations would apply on the loan balance.
Investment Interest
If you use loan proceeds to make taxable investments, the interest paid on the loan can be deducted as investment interest. This type of interest is included on your tax return as an itemized deduction, similar to your mortgage interest. It is limited to the amount of your net investment income (interest, dividends, etc.), however, any excess investment interest can be carried forward and utilized in future tax years. This calculation of deductible investment interest is done on Form 4952 and is also the form that tracks any potential carryforward.
One planning idea for those with paid off homes, is to take a home equity loan out and invest the proceeds. You will need to pay interest on the loan, however, since you used the proceeds to invest, the interest would become deductible without being subject to the mortgage interest limitations. The IRS has specific interest tracing rules, and the IRS requires recordkeeping to ensure the loan proceeds were used for taxable investments; however, if you follow the rules, the interest payments may provide a substantial tax benefit. Also, so long as the interest you pay is less than or equal to the amount of interest and dividend income you earn from your investments, the interest will be fully deductible in each tax year.
Business Interest
If you take a loan out for business purposes, such as to start a business or help fund the operations of your business, the full amount of interest is generally available as a deduction on the business’s income tax return. There are certain limitations for larger businesses under section 163(j); however, for most small businesses the interest is fully deductible on these types of loans.
Personal Loan Interest
If you take out a personal loan or pay interest on a personal debt, such as credit cards, any interest paid is non-deductible on your tax return. Included in this is the interest paid on car loans, since cars are generally for personal use.
Beginning in the 2025 tax year, however, car loan interest may be deductible. For tax years between 2025 and 2028, and for car loans originating after 12/31/2024, you can deduct up to $10,000 of interest payments. This amount is deductible even if you do not itemize your deductions. The amount phases out with income starting at $100,000 (or $200,000 for joint filers) but does apply for personal use vehicles. Historically, these have not been deductible at all, but for the next few tax years, they may be beneficial if you have purchased or plan to purchase a new vehicle.
Student Loan Interest
You can deduct up to $2,500 of student loan interest that is paid on qualified student loans. This deduction is what is referred to as an “above-the-line” adjustment, so you can deduct this amount without being required to itemize your deductions. This deduction is limited if you have income of greater than $85,000 as a single taxpayer (or $175,000 as a joint taxpayer). The amounts are completely non-deductible once your income surpasses $100,000 (or $205,000). These thresholds are for the 2026 tax year and get adjusted for inflation each year.
Summary
In general, your interest payments are only deductible to the extent the loan proceeds were used for a qualified reason. Things such as buying a home, investments, or businesses can create an interest expense deduction, but if you used the loan proceeds for any personal reason, it would limit the amount of deduction available.
There may be multiple uses of loan proceeds, which can create partially deductible interest payments. It is best to consult an advisor and keep detailed records of the use of any loan proceeds, to ensure you are treating the interest payments properly and getting as much tax benefit as you can.
