Very Interesting…but Complicated
By Craig Hackler, Financial Advisor, Raymond James Financial Services
Remember the good old days, when Artie Johnson was on “Laugh-In” and everyone understood how interest expense
deductions worked? Have you noticed that nobody, not even the politicians, claims that the Tax Reform Act of 1986 was
really a “simplification” of the tax code. If you take a look at the rules for deducting interest expense you will long
for the days when the country thought “say good night Dick” was funny.
Interest expense falls into one of five categories; personal interest, investment interest, interest on a home,
interest on a passive investment and interest incurred pursuing an active trade or business. Whether, and how much,
interest will be deductible now depends on how the proceeds of the loan were used as well as a few other factors. A
complex series of tracing rules may have to be used to determine if there is an adequate “paper trail” to allow for the
expense to fall into a permitted category. The first classification of interest expense is personal interest. Personal
interest includes not only such things as credit card interest incurred buying items at the department store, but also
any other interest unless it can be made to fit under one of the other four categories. Personal interest is not
deductible.
Investment interest expense is interest incurred to purchase assets that produce income or capital gains. The
general rule is that investment interest is deductible to the extent of net investment income in excess of the 2%
adjusted gross income floor. “Net investment income” is the gross income from investments (taxable interest, dividends,
net capital gains, etc.) less investment expenses, other than
interest.
Home mortgage interest includes interest secured by a mortgage on your first or second home. If the debt existed
on or before Oct 13, 1987, the debt is 100% deductible regardless of the amount or whether it is a first or second
mortgage. For mortgages incurred after that date, the interest is fully deductible to the extent of $1 million in debt to
acquire or improve the home and up to $100,000 in home equity debt, regardless of how the proceeds of the loan are used.
Special rules apply to refinancing.
The passive loss rules also impact on the deductibility of interest. Interest expense incurred within the passive
activity (e.g. the mortgage on the office building that’s the major asset of the partnership) is considered to be a part
of the net passive income or loss of the activity. Interest incurred to acquire ownership in a passive activity is
considered to be a passive loss. Thus, it is only deductible to the extent of passive income. For certain high income
taxpayers, interest expense deductions, other than investment interest, may be subject to a phase-out rule.
Debt incurred in the conduct of an active trade or business is fully deductible. This deduction is not phased out.
The business must be a genuine business, not a hobby. Also, rental real estate activities, no matter how much time and
effort they take, may not be considered an active trade or business.
Craig Hackler holds the Series 7 and Series 63 Securities licenses, as well as the Group I Insurance license (life,
health, annuities). Through Raymond James Financial Services, he offers complete financial planning and investment
products tailored to the individual needs of his clients. He will gladly answer your questions. Call him at 512.894.0574
or 800.650.9517
|
