Interest Expense Introduction
Types of Interest Expense
The following sections examine the most common categories of interest that are deductible under Code Section 163.
These categories are:
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personal interest; |
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student loan interest; |
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qualified residence interest; |
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trade or business interest, and |
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investment interest. |
Personal interest is defined in a negative manner: It includes all interest other than trade or business interest, investment interest, passive activity interest, qualified residence interest, and interest on estate tax payments that are deferred because of a reversionary interest under Code Section 6163. Thus, any personal interest that does not fall into one of these categories is nondeductible.
Personal interest includes interest on a loan to purchase an automobile for personal use, to purchase a life insurance policy, and credit card interest, where the interest is not incurred or continued in connection with the conduct of a trade or business. The regulations provide that any interest paid on underpayments of individual federal, state, or local income taxes is personal interest, notwithstanding that all or a portion of the additional tax due may be attributable to income generated in the taxpayer's trade or business. While there was some controversy as to whether these regulations were valid, the Fourth, Sixth, Seventh, Eighth, and Ninth Circuits have held that they are.
Not
Deductible
Code Section 221 allows a deduction for interest payments due and paid after December 31, 1997, on any qualified education loan. The interest paid on the qualified education loans may be claimed as an above-the-line deduction, up to a maximum of $2,500 per year. Code Section 221(b)(1). The maximum deduction is phased in over four years, with a $1,000 maximum deduction in 1998, $1,500 in 1999, $2,000 in 2000, and $2,500 in 2001. Code Section 221(b)(1). The $2,500 maximum deduction amount is not indexed for inflation.
The deduction for student loan interest is phased out ratably for individual taxpayers with modified AGI of $40,000 to $55,000 ($60,000 to $75,000 for joint returns). Code Section 221(b)(2). Modified AGI is the taxpayer's AGI determined without reference to Sections 135, 137, 911, 931, and 933, but after the application of Sections 86, 219, and 469.
Code Section 221(b)(2)(C). These income ranges will be indexed for inflation after 2002, rounded down to the closest multiple of $5,000. Code Section 221(g). The deduction under Code Section 221 is allowed only with respect to interest paid on a qualified education loan during the first 60 months in which interest payments are required. Code Section 221(d). Months during which the qualified education loan is in deferral or forbearance do not count against the 60-month period. For purposes of this rule, any loan and all refinancings of the loan are treated as one loan. Code Section 221(d). In the case of a qualified education loan that is not issued or guaranteed under a federal postsecondary education loan program, the 60-month period is suspended only if the borrower satisfies certain conditions established by the U.S. Department of Education. Prop. Reg.
Section 1.221-1(e)(3). No deduction is allowed for interest on a payment required to be made before the end of the 60-month period that is actually made after the 60-month period. Prop. Reg. Section 1.221-1(e)(4).
"Qualified residence interest" is not subject to the limitation on personal interest. Code Section 163(h)(2)(D). Qualified residence interest basically means interest paid or accrued during the taxable year on debt secured by either (1) the taxpayer's principal residence, or (2) one second dwelling unit of the taxpayer to the extent it is considered to be used as a residence within the meaning of Code Section 280A(d)(1).
Code Section 163(h)(4)(A)(i).
Qualified residence interest is limited to amounts paid or incurred on "acquisition indebtedness" and "home equity indebtedness." Code Section 163(h)(3)(A). "Acquisition indebtedness" is debt that is both (1) secured by a qualified residence and (2) incurred in acquiring, constructing or substantially improving the residence. Code Section 163(h)(3)(B)(i).
However, the total of acquisition, construction, and improvement loans taken into account is limited to $1,000,000 ($500,000 in the case of married individuals filing separately). Code Section 163(h)(3)(B)(ii). Indebtedness secured by a qualified residence that is not acquisition indebtedness is considered "home equity indebtedness" to the extent of the difference between the amount of outstanding acquisition indebtedness and the fair market value of the qualified residence (the equity). Code Section 163(h)(3)(C)(i). Home equity indebtedness resulting in deductible qualified residence interest may not exceed $100,000 ($50,000 in the case of married individuals filing separately). Code Section 163(h)(3)(C)(ii).
Disallowed investment interest may be deducted in a subsequent year only to the extent the taxpayer has net investment income in that year, but may be carried forward indefinitely. In response to a series of losses in court, the IRS ruled in Rev. Rul. 95-16, 1995- 1 C.B. 9, that the amount of disallowed investment interest that can be carried forward is not limited to the taxpayer's taxable income in the year of the disallowance. This ruling reversed an earlier position of the IRS that the carryover was available only to the extent that Code Section 163(d) alone caused interest not to be deductible. Rev. Rul. 86-70, 1986-1 C.B. 83. In Rev. Rul. 86-70, the IRS reasoned that if the taxpayer's taxable income was less than the amount of the disallowed interest deduction, the excess interest would not have been deductible in any event, and no carryover should be allowed. The IRS believed that Code Section 163(d) was intended to disallow (or defer) the deduction of excess investment interest and not to create a carryover for interest that otherwise would be nondeductible. However, in light of the case law on the subject, the IRS reversed its position with the issuance of Rev. Rul. 95-16, above.
Investment interest is interest paid or accrued on indebtedness properly allocable to property held for investment. Code Section 163(d)(3)(A). Qualified residence interest and passive activity interest are specifically excluded from investment interest. Code Section 163(d)(3)(B)(ii).
WHAT IS INVESTMENT PROPERTY? |
| Property held for investment is defined by reference to the passive activity loss rules. Property held for investment is property that produces income that would be considered "portfolio income". Portfolio income is interest income, dividend income, etc. Property held for investment also includes an interest in an activity of conducting a trade or business in which you did not materially participate and that is not a passive activity. For example, a working interest in an oil or gas property that you held directly or through an entity that did not limit your liability is property held for investment if you did not materially participate in the activity. Property held for investment includes property that produces income (unless derived in the ordinary course of a trade or business) from interest, dividends, annuities, or royalties; and gains from the disposition of property that produces those types of income or is held for investment. However, it does not include an interest in a passive activity. It also includes any interest in an activity involving the conduct of a trade or business that is not a passive activity with respect to which the taxpayer does not materially participate. Code Section 163(d)(5)(A). A working interest in an oil and gas property is excluded from the definition of a passive activity under Code Section 469 and thus is property held for investment, unless the taxpayer materially participates. Code Section 469(c)(3).
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Net capital gain from the disposition of property held for investment is excluded from investment income. However, you may elect to include in investment income all or part of the net capital gain from the disposition of property held for investment. If you make the election, you also must reduce the amount of net capital gain eligible for capital gains tax rates by the amount of net capital gain you included in investment income. Therefore, you should consider the effect on your tax using the capital gains tax rates before making this election. Once made, the election may only be revoked with IRS consent.
To make the election, enter on line 4e the amount that you elect to include in investment income. Also enter this amount on line 21 of Schedule D (Form 1040), or on line 20 of Schedule D (Form 1041), if applicable. You must generally make this election on a timely filed return (including extensions). However, if you timely filed your return without making the election, you can also make the election on an amended return filed within 6 months of the due date of your return (excluding extensions). Write "Filed pursuant to section 301.9100-2" on the amended return and file it at the same place you filed the original return.
Include investment expenses reported to you on Schedule K-1 from a partnership or an S corporation. If you have investment expenses that are included as a miscellaneous itemized deduction on Schedule A (Form 1040), line 22, you may not have to use the entire amount for purposes of Form 4952, line 5.
The 2% adjusted gross income limitation on Schedule A (Form 1040), line 25, may reduce the amount you must include on Form 4952, line 5. Include on Form 4952, line 5, only the smaller of:
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The investment expenses included on Schedule A (Form 1040), line 22, or |
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The total on Schedule A (Form 1040), line 26. |
Gross income from property held for investment to enter on line 4a includes income (unless derived in the ordinary course of a trade or business) from:
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Interest, |
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Ordinary dividends (except Alaska Permanent Fund dividends), |
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Annuities, and |
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Royalties. |
Also, include on line 4a net income from the following passive activities:
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Rental of substantially nondepreciable property, |
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Equity-financed lending activities, and |
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Acquisition of certain interests in a pass-through entity licensing intangible property. |
Also include on line 4a (or 4b, if applicable) net passive income from a passive activity of a publicly traded partnership (as defined in section 469(k)(2)). See Notice 88-75, 1988-2 C.B. 386, for details.
Include investment income reported to you on Schedule K-1 from a partnership or an S corporation. Also include net investment income from an estate or a trust.
Caution: Do not include on line 4a any net gain from the disposition of property held for investment. Instead, enter it on line 4b.
Net gain from the disposition of property held for investment is the excess, if any, of total gains over total losses from the disposition of property held for investment. When figuring this amount, include capital gain distributions from mutual funds.