23.   Interest Expense

Introduction

This chapter discusses what interest expenses you can deduct. Interest is the amount you pay for the use of borrowed money.

The following are types of interest you can deduct as itemized deductions on Schedule A (Form 1040).

  • Home mortgage interest, including certain points and mortgage insurance premiums.

  • Investment interest.

This chapter explains these deductions. It also explains where to deduct other types of interest and lists some types of interest you cannot deduct.

Use Table 23-1 to find out where to get more information on various types of interest, including investment interest.

Useful Items - You may want to see:

Publication

  • 936 Home Mortgage Interest Deduction

  • 550 Investment Income and Expenses

Home Mortgage Interest

Generally, home mortgage interest is any interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan.

You can deduct home mortgage interest if all the following conditions are met.

  • You file Form 1040 and itemize deductions on Schedule A (Form 1040).

  • The mortgage is a secured debt on a qualified home in which you have an ownership interest. (Generally, your mortgage is a secured debt if you put your home up as collateral to protect the interest of the lender. The term “qualified home” means your main home or second home. For details, see Publication 936.)

 
Both you and the lender must intend that the loan be repaid.

Amount Deductible

In most cases, you can deduct all of your home mortgage interest. How much you can deduct depends on the date of the mortgage, the amount of the mortgage, and how you use the mortgage proceeds.

Fully deductible interest.   If all of your mortgages fit into one or more of the following three categories at all times during the year, you can deduct all of the interest on those mortgages. (If any one mortgage fits into more than one category, add the debt that fits in each category to your other debt in the same category.)

  The three categories are as follows:
  1. Mortgages you took out on or before October 13, 1987 (called grandfathered debt).

  2. Mortgages you took out after October 13, 1987, to buy, build, or improve your home (called home acquisition debt), but only if throughout 2013 these mortgages plus any grandfathered debt totaled $1 million or less ($500,000 or less if married filing separately).

  3. Mortgages you took out after October 13, 1987, other than to buy, build, or improve your home (called home equity debt), but only if throughout 2013 these mortgages totaled $100,000 or less ($50,000 or less if married filing separately) and totaled no more than the fair market value of your home reduced by (1) and (2).

The dollar limits for the second and third categories apply to the combined mortgages on your main home and second home.

  See Part II of Publication 936 for more detailed definitions of grandfathered, home acquisition, and home equity debt.

   You can use Figure 23-A to check whether your home mortgage interest is fully deductible.

Figure 23-A. Is My Home Mortgage Interest Fully Deductible?

Figure 23-A. Is My Home Mortgage Interest Fully Deductible?
Please click here for the text description of the image.

Figure 23-A. Is My Interest Fully Deductible?

Limits on deduction.   You cannot fully deduct interest on a mortgage that does not fit into any of the three categories listed earlier. If this applies to you, see Part II of Publication 936 to figure the amount of interest you can deduct.

Special Situations

This section describes certain items that can be included as home mortgage interest and others that cannot. It also describes certain special situations that may affect your deduction.

Late payment charge on mortgage payment.   You can deduct as home mortgage interest a late payment charge if it was not for a specific service performed in connection with your mortgage loan.

Mortgage prepayment penalty.   If you pay off your home mortgage early, you may have to pay a penalty. You can deduct that penalty as home mortgage interest provided the penalty is not for a specific service performed or cost incurred in connection with your mortgage loan.

Sale of home.   If you sell your home, you can deduct your home mortgage interest (subject to any limits that apply) paid up to, but not including, the date of sale.

Example.

John and Peggy Harris sold their home on May 7. Through April 30, they made home mortgage interest payments of $1,220. The settlement sheet for the sale of the home showed $50 interest for the 6-day period in May up to, but not including, the date of sale. Their mortgage interest deduction is $1,270 ($1,220 + $50).

Prepaid interest.   If you pay interest in advance for a period that goes beyond the end of the tax year, you must spread this interest over the tax years to which it applies. You can deduct in each year only the interest that qualifies as home mortgage interest for that year. However, there is an exception that applies to points, discussed later.

Mortgage interest credit.   You may be able to claim a mortgage interest credit if you were issued a mortgage credit certificate (MCC) by a state or local government. Figure the credit on Form 8396, Mortgage Interest Credit. If you take this credit, you must reduce your mortgage interest deduction by the amount of the credit.

  For more information on the credit, see chapter 37.

Ministers' and military housing allowance.   If you are a minister or a member of the uniformed services and receive a housing allowance that is not taxable, you can still deduct your home mortgage interest.

Hardest Hit Fund and Emergency Homeowners' Loan Programs.   You can use a special method to compute your deduction for mortgage interest and real estate taxes on your main home if you meet the following two conditions.
  1. You received assistance under:

    1. A State Housing Finance Agency (State HFA) Hardest Hit Fund program in which program payments could be used to pay mortgage interest, or

    2. An Emergency Homeowners' Loan Program administered by the Department of Housing and Urban Development (HUD) or a state.

  2. You meet the rules to deduct all of the mortgage interest on your loan and all of the real estate taxes on your main home.

If you meet these tests, then you can deduct all of the payments you actually made during the year to your mortgage servicer, the State HFA, or HUD on the home mortgage (including the amount shown on box 3 of Form 1098-MA, Mortgage Assistance Payments), but not more than the sum of the amounts shown on Form 1098, Mortgage Interest Statement, in box 1 (mortgage interest received from payer(s) / borrower(s)), box 4 (mortgage insurance premiums) and box 5 (real property taxes). However, you are not required to use this special method to compute your deduction for mortgage interest and real estate taxes on your main home.

Mortgage assistance payments under section 235 of the National Housing Act.   If you qualify for mortgage assistance payments for lower-income families under section 235 of the National Housing Act, part or all of the interest on your mortgage may be paid for you. You cannot deduct the interest that is paid for you.

No other effect on taxes.   Do not include these mortgage assistance payments in your income. Also, do not use these payments to reduce other deductions, such as real estate taxes.

Divorced or separated individuals.   If a divorce or separation agreement requires you or your spouse or former spouse to pay home mortgage interest on a home owned by both of you, the payment of interest may be alimony. See the discussion of Payments for jointly-owned home in chapter 18.

Redeemable ground rents.   If you make annual or periodic rental payments on a redeemable ground rent, you can deduct them as mortgage interest.

  Payments made to end the lease and to buy the lessor's entire interest in the land are not deductible as mortgage interest. For more information, see Publication 936.

Nonredeemable ground rents.   Payments on a nonredeemable ground rent are not mortgage interest. You can deduct them as rent if they are a business expense or if they are for rental property.

Reverse mortgages.   A reverse mortgage is a loan where the lender pays you (in a lump sum, a monthly advance, a line of credit, or a combination of all three) while you continue to live in your home. With a reverse mortgage, you retain title to your home. Depending on the plan, your reverse mortgage becomes due with interest when you move, sell your home, reach the end of a pre-selected loan period, or die. Because reverse mortgages are considered loan advances and not income, the amount you receive is not taxable. Any interest (including original issue discount) accrued on a reverse mortgage is not deductible until the loan is paid in full. Your deduction may be limited because a reverse mortgage loan generally is subject to the limit on Home Equity Debt discussed in Publication 936.

Rental payments.   If you live in a house before final settlement on the purchase, any payments you make for that period are rent and not interest. This is true even if the settlement papers call them interest. You cannot deduct these payments as home mortgage interest.

Mortgage proceeds invested in tax-exempt securities.   You cannot deduct the home mortgage interest on grandfathered debt or home equity debt if you used the proceeds of the mortgage to buy securities or certificates that produce tax-free income. “Grandfathered debt” and “home equity debt” are defined earlier under Amount Deductible.

Refunds of interest.   If you receive a refund of interest in the same tax year you paid it, you must reduce your interest expense by the amount refunded to you. If you receive a refund of interest you deducted in an earlier year, you generally must include the refund in income in the year you receive it. However, you need to include it only up to the amount of the deduction that reduced your tax in the earlier year. This is true whether the interest overcharge was refunded to you or was used to reduce the outstanding principal on your mortgage.

   If you received a refund of interest you overpaid in an earlier year, you generally will receive a Form 1098, Mortgage Interest Statement, showing the refund in box 3. For information about Form 1098, see Form 1098, Mortgage Interest Statement , later.

  For more information on how to treat refunds of interest deducted in earlier years, see Recoveries in chapter 12.

Points

The term “points” is used to describe certain charges paid, or treated as paid, by a borrower to obtain a home mortgage. Points may also be called loan origination fees, maximum loan charges, loan discount, or discount points.

A borrower is treated as paying any points that a home seller pays for the borrower's mortgage. See Points paid by the seller , later.

General Rule

You generally cannot deduct the full amount of points in the year paid. Because they are prepaid interest, you generally deduct them ratably over the life (term) of the mortgage. See Deduction Allowed Ratably , next.

For exceptions to the general rule, see Deduction Allowed in Year Paid , later.

Deduction Allowed Ratably

If you do not meet the tests listed under Deduction Allowed in Year Paid , later, the loan is not a home improvement loan, or you choose not to deduct your points in full in the year paid, you can deduct the points ratably (equally) over the life of the loan if you meet all the following tests.

  1. You use the cash method of accounting. This means you report income in the year you receive it and deduct expenses in the year you pay them. Most individuals use this method.

  2. Your loan is secured by a home. (The home does not need to be your main home.)

  3. Your loan period is not more than 30 years.

  4. If your loan period is more than 10 years, the terms of your loan are the same as other loans offered in your area for the same or longer period.

  5. Either your loan amount is $250,000 or less, or the number of points is not more than:

    1. 4, if your loan period is 15 years or less, or

    2. 6, if your loan period is more than 15 years.

Deduction Allowed in Year Paid

You can fully deduct points in the year paid if you meet all the following tests. (You can use Figure 23-B as a quick guide to see whether your points are fully deductible in the year paid.)

  1. Your loan is secured by your main home. (Your main home is the one you ordinarily live in most of the time.)

  2. Paying points is an established business practice in the area where the loan was made.

  3. The points paid were not more than the points generally charged in that area.

  4. You use the cash method of accounting. This means you report income in the year you receive it and deduct expenses in the year you pay them. (If you want more information about this method, see Accounting Methods in chapter 1.)

  5. The points were not paid in place of amounts that ordinarily are stated separately on the settlement statement, such as appraisal fees, inspection fees, title fees, attorney fees, and property taxes.

  6. The funds you provided at or before closing, plus any points the seller paid, were at least as much as the points charged. The funds you provided are not required to have been applied to the points. They can include a down payment, an escrow deposit, earnest money, and other funds you paid at or before closing for any purpose. You cannot have borrowed these funds from your lender or mortgage broker.

  7. You use your loan to buy or build your main home.

  8. The points were computed as a percentage of the principal amount of the mortgage.

  9. The amount is clearly shown on the settlement statement (such as the Settlement Statement, Form HUD-1) as points charged for the mortgage. The points may be shown as paid from either your funds or the seller's.

Figure 23-B. Are My Points Fully Deductible This Year?

Figure 23-B. Are My Points Fully Deductible This Year?
Please click here for the text description of the image.

Figure 23-B. Are My Points Fully Deductible This Year?

Note.

If you meet all of these tests, you can choose to either fully deduct the points in the year paid, or deduct them over the life of the loan.

Home improvement loan.   You can also fully deduct in the year paid points paid on a loan to improve your main home, if tests (1) through (6) are met.

Second home. You cannot fully deduct in the year paid points you pay on loans secured by your second home. You can deduct these points only over the life of the loan.

Refinancing.   Generally, points you pay to refinance a mortgage are not deductible in full in the year you pay them. This is true even if the new mortgage is secured by your main home.

  However, if you use part of the refinanced mortgage proceeds to improve your main home and you meet the first 6 tests listed under Deduction Allowed in Year Paid , earlier, you can fully deduct the part of the points related to the improvement in the year you paid them with your own funds. You can deduct the rest of the points over the life of the loan.

Example 1.

In 1998, Bill Fields got a mortgage to buy a home. In 2013, Bill refinanced that mortgage with a 15-year $100,000 mortgage loan. The mortgage is secured by his home. To get the new loan, he had to pay three points ($3,000). Two points ($2,000) were for prepaid interest, and one point ($1,000) was charged for services, in place of amounts that ordinarily are stated separately on the settlement statement. Bill paid the points out of his private funds, rather than out of the proceeds of the new loan. The payment of points is an established practice in the area, and the points charged are not more than the amount generally charged there. Bill's first payment on the new loan was due July 1. He made six payments on the loan in 2013 and is a cash basis taxpayer.

Bill used the funds from the new mortgage to repay his existing mortgage. Although the new mortgage loan was for Bill's continued ownership of his main home, it was not for the purchase or improvement of that home. He cannot deduct all of the points in 2013. He can deduct two points ($2,000) ratably over the life of the loan. He deducts $67 [($2,000 ÷ 180 months) × 6 payments] of the points in 2013. The other point ($1,000) was a fee for services and is not deductible.

Example 2.

The facts are the same as in Example 1, except that Bill used $25,000 of the loan proceeds to improve his home and $75,000 to repay his existing mortgage. Bill deducts 25% ($25,000 ÷ $100,000) of the points ($2,000) in 2013. His deduction is $500 ($2,000 × 25%).

Bill also deducts the ratable part of the remaining $1,500 ($2,000 − $500) that must be spread over the life of the loan. This is $50 [($1,500 ÷ 180 months) × 6 payments] in 2013. The total amount Bill deducts in 2013 is $550 ($500 + $50).

Special Situations

This section describes certain special situations that may affect your deduction of points.

Original issue discount.   If you do not qualify to either deduct the points in the year paid or deduct them ratably over the life of the loan, or if you choose not to use either of these methods, the points reduce the issue price of the loan. This reduction results in original issue discount, which is discussed in chapter 4 of Publication 535.

Amounts charged for services.   Amounts charged by the lender for specific services connected to the loan are not interest. Examples of these charges are:
  • Appraisal fees,

  • Notary fees, and

  • Preparation costs for the mortgage note or deed of trust.

You cannot deduct these amounts as points either in the year paid or over the life of the mortgage.

Points paid by the seller.   The term “points” includes loan placement fees that the seller pays to the lender to arrange financing for the buyer.

Treatment by seller.   The seller cannot deduct these fees as interest. But they are a selling expense that reduces the amount realized by the seller. See chapter 15 for information on selling your home.

Treatment by buyer.    The buyer reduces the basis of the home by the amount of the seller-paid points and treats the points as if he or she had paid them. If all the tests under Deduction Allowed in Year Paid , earlier, are met, the buyer can deduct the points in the year paid. If any of those tests are not met, the buyer deducts the points over the life of the loan.

  For information about basis, see chapter 13.

Funds provided are less than points.   If you meet all the tests in Deduction Allowed in Year Paid , earlier, except that the funds you provided were less than the points charged to you (test (6)), you can deduct the points in the year paid, up to the amount of funds you provided. In addition, you can deduct any points paid by the seller.

Example 1.

When you took out a $100,000 mortgage loan to buy your home in December, you were charged one point ($1,000). You meet all the tests for deducting points in the year paid, except the only funds you provided were a $750 down payment. Of the $1,000 charged for points, you can deduct $750 in the year paid. You spread the remaining $250 over the life of the mortgage.

Example 2.

The facts are the same as in Example 1, except that the person who sold you your home also paid one point ($1,000) to help you get your mortgage. In the year paid, you can deduct $1,750 ($750 of the amount you were charged plus the $1,000 paid by the seller). You spread the remaining $250 over the life of the mortgage. You must reduce the basis of your home by the $1,000 paid by the seller.

Excess points.   If you meet all the tests in Deduction Allowed in Year Paid , earlier, except that the points paid were more than generally paid in your area (test (3)), you deduct in the year paid only the points that are generally charged. You must spread any additional points over the life of the mortgage.

Mortgage ending early.   If you spread your deduction for points over the life of the mortgage, you can deduct any remaining balance in the year the mortgage ends. However, if you refinance the mortgage with the same lender, you cannot deduct any remaining balance of spread points. Instead, deduct the remaining balance over the term of the new loan.

   A mortgage may end early due to a prepayment, refinancing, foreclosure, or similar event.

Example.

Dan paid $3,000 in points in 2002 that he had to spread out over the 15-year life of the mortgage. He deducts $200 points per year. Through 2012, Dan has deducted $2,200 of the points.

Dan prepaid his mortgage in full in 2013. He can deduct the remaining $800 of points in 2013.

Limits on deduction.   You cannot fully deduct points paid on a mortgage unless the mortgage fits into one of the categories listed earlier under Fully deductible interest . See Publication 936 for details.

Mortgage Insurance Premiums

You can treat amounts you paid during 2013 for qualified mortgage insurance as home mortgage interest. The insurance must be in connection with home acquisition debt and the insurance contract must have been issued after 2006.

Qualified mortgage insurance.   Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, or the Rural Housing Service, and private mortgage insurance (as defined in section 2 of the Homeowners Protection Act of 1998 as in effect on December 20, 2006).

  Mortgage insurance provided by the Department of Veterans Affairs is commonly known as a funding fee. If provided by the Rural Housing Service, it is commonly known as a guarantee fee. These fees can be deducted fully in 2013 if the mortgage insurance contract was issued in 2013. Contact the mortgage insurance issuer to determine the deductible amount if it is not reported in box 4 of Form 1098.

Special rules for prepaid mortgage insurance.   Generally, if you paid premiums for qualified mortgage insurance that are allocable to periods after the close of the tax year, such premiums are treated as paid in the period to which they are allocated. You must allocate the premiums over the shorter of the stated term of the mortgage or 84 months, beginning with the month the insurance was obtained. No deduction is allowed for the unamortized balance if the mortgage is satisfied before its term. This paragraph does not apply to qualified mortgage insurance provided by the Department of Veterans Affairs or the Rural Housing Service. See the Example below.

Example.

Ryan purchased a home in May of 2012 and financed the home with a 15-year mortgage. Ryan also prepaid all of the $9,240 in private mortgage insurance required at the time of closing in May. Since the $9,240 in private mortgage insurance is allocable to periods after 2012, Ryan must allocate the $9,240 over the shorter of the life of the mortgage or 84 months. Ryan's adjusted gross income (AGI) for 2012 is $76,000. Ryan can deduct $880 ($9,240 ÷ 84 × 8 months) for qualified mortgage insurance premiums in 2012. For 2013, Ryan can deduct $1,320 ($9,240 ÷ 84 × 12 months) if his AGI is $100,000 or less.

In this example, the mortgage insurance premiums are allocated over 84 months, which is shorter than the life of the mortgage of 15 years (180 months).

Limit on deduction.   If your adjusted gross income on Form 1040, line 38, is more than $100,000 ($50,000 if your filing status is married filing separately), the amount of your mortgage insurance premiums that are otherwise deductible is reduced and may be eliminated. See Line 13 in the instructions for Schedule A (Form 1040) and complete the Mortgage Insurance Premiums Deduction Worksheet to figure the amount you can deduct. If your adjusted gross income is more than $109,000 ($54,500 if married filing separately), you cannot deduct your mortgage insurance premiums.

Form 1098, Mortgage Interest Statement

If you paid $600 or more of mortgage interest (including certain points and mortgage insurance premiums) during the year on any one mortgage, you generally will receive a Form 1098 or a similar statement from the mortgage holder. You will receive the statement if you pay interest to a person (including a financial institution or a cooperative housing corporation) in the course of that person's trade or business. A governmental unit is a person for purposes of furnishing the statement.

The statement for each year should be sent to you by January 31 of the following year. A copy of this form will also be sent to the IRS.

The statement will show the total interest you paid during the year, any mortgage insurance premiums you paid, and if you purchased a main home during the year, it also will show the deductible points paid during the year, including seller-paid points. However, it should not show any interest that was paid for you by a government agency.

As a general rule, Form 1098 will include only points that you can fully deduct in the year paid. However, certain points not included on Form 1098 also may be deductible, either in the year paid or over the life of the loan. See Points , earlier, to determine whether you can deduct points not shown on Form 1098.

Prepaid interest on Form 1098.   If you prepaid interest in 2013 that accrued in full by January 15, 2014, this prepaid interest may be included in box 1 of Form 1098. However, you cannot deduct the prepaid amount for January 2014 in 2013. (See Prepaid interest , earlier.) You will have to figure the interest that accrued for 2014 and subtract it from the amount in box 1. You will include the interest for January 2014 with the other interest you pay for 2014. See How To Report , later.

Refunded interest.   If you received a refund of mortgage interest you overpaid in an earlier year, you generally will receive a Form 1098 showing the refund in box 3. See Refunds of interest , earlier.

Mortgage insurance premiums.   The amount of mortgage insurance premiums you paid during 2013 may be shown in box 4 of Form 1098. See Mortgage Insurance Premiums, earlier.

Investment Interest

This section discusses interest expenses you may be able to deduct as an investor.

If you borrow money to buy property you hold for investment, the interest you pay is investment interest. You can deduct investment interest subject to the limit discussed later. However, you cannot deduct interest you incurred to produce tax-exempt income. Nor can you deduct interest expenses on straddles.

Investment interest does not include any qualified home mortgage interest or any interest taken into account in computing income or loss from a passive activity.

Investment Property

Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity).

Partners, shareholders, and beneficiaries.   To determine your investment interest, combine your share of investment interest from a partnership, S corporation, estate, or trust with your other investment interest.

Allocation of Interest Expense

If you borrow money for business or personal purposes as well as for investment, you must allocate the debt among those purposes. Only the interest expense on the part of the debt used for investment purposes is treated as investment interest. The allocation is not affected by the use of property that secures the debt.

Limit on Deduction

Generally, your deduction for investment interest expense is limited to the amount of your net investment income.

You can carry over the amount of investment interest that you could not deduct because of this limit to the next tax year. The interest carried over is treated as investment interest paid or accrued in that next year.

You can carry over disallowed investment interest to the next tax year even if it is more than your taxable income in the year the interest was paid or accrued.

Net Investment Income

Determine the amount of your net investment income by subtracting your investment expenses (other than interest expense) from your investment income.

Investment income.    This generally includes your gross income from property held for investment (such as interest, dividends, annuities, and royalties). Investment income does not include Alaska Permanent Fund dividends. It also does not include qualified dividends or net capital gain unless you choose to include them.

Choosing to include qualified dividends.   Investment income generally does not include qualified dividends, discussed in chapter 8. However, you can choose to include all or part of your qualified dividends in investment income.

  You make this choice by completing Form 4952, line 4g, according to its instructions.

  If you choose to include any amount of your qualified dividends in investment income, you must reduce your qualified dividends that are eligible for the lower capital gains tax rates by the same amount.

Choosing to include net capital gain.   Investment income generally does not include net capital gain from disposing of investment property (including capital gain distributions from mutual funds). However, you can choose to include all or part of your net capital gain in investment income.

   You make this choice by completing Form 4952, line 4g, according to its instructions.

  If you choose to include any amount of your net capital gain in investment income, you must reduce your net capital gain that is eligible for the lower capital gains tax rates by the same amount.

  
Before making either choice, consider the overall effect on your tax liability. Compare your tax if you make one or both of these choices with your tax if you do not.

Investment income of child reported on parent's return.    Investment income includes the part of your child's interest and dividend income that you choose to report on your return. If the child does not have qualified dividends, Alaska Permanent Fund dividends, or capital gain distributions, this is the amount on line 6 of Form 8814, Parents' Election To Report Child's Interest and Dividends.

Child's qualified dividends.   If part of the amount you report is your child's qualified dividends, that part (which is reported on Form 1040, line 9b) generally does not count as investment income. However, you can choose to include all or part of it in investment income, as explained under Choosing to include qualified dividends , earlier.

  Your investment income also includes the amount on Form 8814, line 12 (or, if applicable, the reduced amount figured next under Child's Alaska Permanent Fund dividends).

Child's Alaska Permanent Fund dividends.   If part of the amount you report is your child's Alaska Permanent Fund dividends, that part does not count as investment income. To figure the amount of your child's income that you can consider your investment income, start with the amount on Form 8814, line 6. Multiply that amount by a percentage that is equal to the Alaska Permanent Fund dividends divided by the total amount on Form 8814, line 4. Subtract the result from the amount on Form 8814, line 12.

Child's capital gain distributions.    If part of the amount you report is your child's capital gain distributions, that part (which is reported on Schedule D, line 13, or Form 1040, line 13) generally does not count as investment income. However, you can choose to include all or part of it in investment income, as explained in Choosing to include net capital gain , earlier.

  Your investment income also includes the amount on Form 8814, line 12 (or, if applicable, the reduced amount figured under Child's Alaska Permanent Fund dividends , earlier).

Investment expenses.   Investment expenses are your allowed deductions (other than interest expense) directly connected with the production of investment income. Investment expenses that are included as a miscellaneous itemized deduction on Schedule A (Form 1040) are allowable deductions after applying the 2% limit that applies to miscellaneous itemized deductions. Use the smaller of:
  • The investment expenses included on Schedule A (Form 1040), line 23, or

  • The amount on Schedule A, line 27.

Losses from passive activities.   Income or expenses that you used in computing income or loss from a passive activity are not included in determining your investment income or investment expenses (including investment interest expense). See Publication 925, Passive Activity and At-Risk Rules, for information about passive activities.

Form 4952

Use Form 4952, Investment Interest Expense Deduction, to figure your deduction for investment interest.

Exception to use of Form 4952.   You do not have to complete Form 4952 or attach it to your return if you meet all of the following tests.
  • Your investment interest expense is not more than your investment income from interest and ordinary dividends minus any qualified dividends.

  • You do not have any other deductible investment expenses.

  • You have no carryover of investment interest expense from 2012.

If you meet all of these tests, you can deduct all of your investment interest.

More Information

For more information on investment interest, see Interest Expenses in chapter 3 of Publication 550.

Items You Cannot Deduct

Some interest payments are not deductible. Certain expenses similar to interest also are not deductible. Nondeductible expenses include the following items.

  • Personal interest (discussed later).

  • Service charges (however, see Other Expenses (Line 23) in chapter 28).

  • Annual fees for credit cards.

  • Loan fees.

  • Credit investigation fees.

  • Interest to purchase or carry tax-exempt securities.

Penalties.   You cannot deduct fines and penalties paid to a government for violations of law, regardless of their nature.

Personal Interest

Personal interest is not deductible. Personal interest is any interest that is not home mortgage interest, investment interest, business interest, or other deductible interest. It includes the following items.

  • Interest on car loans (unless you use the car for business).

  • Interest on federal, state, or local income tax.

  • Finance charges on credit cards, retail installment contracts, and revolving charge accounts incurred for personal expenses.

  • Late payment charges by a public utility.

You may be able to deduct interest you pay on a qualified student loan. For details, see Publication 970, Tax Benefits for Education.

Allocation of Interest

If you use the proceeds of a loan for more than one purpose (for example, personal and business), you must allocate the interest on the loan to each use. However, you do not have to allocate home mortgage interest if it is fully deductible, regardless of how the funds are used.

You allocate interest (other than fully deductible home mortgage interest) on a loan in the same way as the loan itself is allocated. You do this by tracing disbursements of the debt proceeds to specific uses. For details on how to do this, see chapter 4 of Publication 535.

How To Report

You must file Form 1040 to deduct any home mortgage interest expense on your tax return. Where you deduct your interest expense generally depends on how you use the loan proceeds. See Table 23-1 for a summary of where to deduct your interest expense.

Home mortgage interest and points.   Deduct the home mortgage interest and points reported to you on Form 1098 on Schedule A (Form 1040), line 10. If you paid more deductible interest to the financial institution than the amount shown on Form 1098, show the larger deductible amount on line 10. Attach a statement explaining the difference and print “See attached” next to line 10.

   Deduct home mortgage interest that was not reported to you on Form 1098 on Schedule A (Form 1040), line 11. If you paid home mortgage interest to the person from whom you bought your home, show that person's name, address, and taxpayer identification number (TIN) on the dotted lines next to line 11. The seller must give you this number and you must give the seller your TIN. A Form W-9, Request for Taxpayer Identification Number and Certification, can be used for this purpose. Failure to meet any of these requirements may result in a $50 penalty for each failure. The TIN can be either a social security number, an individual taxpayer identification number (issued by the Internal Revenue Service), or an employer identification number. See Social Security Number (SSN) in chapter 1 for more information about TINs.

   If you can take a deduction for points that were not reported to you on Form 1098, deduct those points on Schedule A (Form 1040), line 12.

  Deduct mortgage insurance premiums on Schedule A (Form 1040), line 13.

More than one borrower.   If you and at least one other person (other than your spouse if you file a joint return) were liable for and paid interest on a mortgage that was for your home, and the other person received a Form 1098 showing the interest that was paid during the year, attach a statement to your return explaining this. Show how much of the interest each of you paid, and give the name and address of the person who received the form. Deduct your share of the interest on Schedule A (Form 1040), line 11, and print “See attached” next to the line. Also, deduct your share of any qualified mortgage insurance premiums on Schedule A (Form 1040), line 13.

  Similarly, if you are the payer of record on a mortgage on which there are other borrowers entitled to a deduction for the interest shown on the Form 1098 you received, deduct only your share of the interest on Schedule A (Form 1040), line 10. You should let each of the other borrowers know what his or her share is.

Mortgage proceeds used for business or investment.    If your home mortgage interest deduction is limited, but all or part of the mortgage proceeds were used for business, investment, or other deductible activities, see Table 23-1. It shows where to deduct the part of your excess interest that is for those activities.

Investment interest.    Deduct investment interest, subject to certain limits discussed in Publication 550, on Schedule A (Form 1040), line 14.

Amortization of bond premium.   There are various ways to treat the premium you pay to buy taxable bonds. See Bond Premium Amortization in Publication 550.

Income-producing rental or royalty interest.   Deduct interest on a loan for income-producing rental or royalty property that is not used in your business in Part I of Schedule E (Form 1040).

Example.

You rent out part of your home and borrow money to make repairs. You can deduct only the interest payment for the rented part in Part I of Schedule E (Form 1040). Deduct the rest of the interest payment on Schedule A (Form 1040) if it is deductible home mortgage interest.

Table 23-1. Where To Deduct Your Interest Expense

IF you have ... THEN deduct it on ... AND for more information go to ...
deductible student loan interest Form 1040, line 33, or Form 1040A, line 18 Publication 970.
deductible home mortgage interest and points reported on Form 1098 Schedule A (Form 1040), line 10 Publication 936.
deductible home mortgage interest not reported on Form 1098 Schedule A (Form 1040), line 11 Publication 936.
deductible points not reported on Form 1098 Schedule A (Form 1040), line 12 Publication 936.
deductible mortgage insurance premiums Schedule A (Form 1040), line 13 Publication 936.
deductible investment interest (other than incurred to produce rents or royalties) Schedule A (Form 1040), line 14 Publication 550.
deductible business interest (non-farm) Schedule C or C-EZ (Form 1040) Publication 535.
deductible farm business interest Schedule F (Form 1040) Publications 225 and 535.
deductible interest incurred to produce rents or royalties Schedule E (Form 1040) Publications 527 and 535.
personal interest not deductible.

More Online Publications