What Is Tax-Deductible Interest?

Tax-Deductible Interest Explained

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Tax-deductible interest is interest paid on loans that the IRS allows you to subtract from your taxable income. You might pay at least one type of interest that's tax-deductible.

But you can’t just subtract this interest from your earnings and pay tax on the remaining amount. You must report your tax-deductible interest to the IRS, and this invariably means filing additional forms with your tax return. Numerous rules apply as to when, how, and if you can claim these deductions.  

Definition and Examples of Tax-Deductible Interest

You must pay interest in most cases when you borrow money. It’s the price you pay for the loan. Whether you can deduct it on your tax return depends on the type of loan and interest accrued, as well as if it is accepted by the Internal Revenue Code (IRC). 

The IRC does not give a nod of approval to interest paid on auto loans, credit cards, or any that’s related to tax-exempt income. But you can subtract or deduct interest incurred for other personal purposes deemed acceptable, including student loans, investments, and qualified mortgages.

How Tax-Deductible Interest Works

Some tax-deductible interest must be claimed as an itemized deduction. This means foregoing the standard deduction for your filing status, which is pretty significant in 2021: $12,550 if you’re single, or double that to $25,100 if you’re married and filing a joint return. You would need itemized deductions totaling more than the applicable standard deduction to make itemizing worth your while financially. 

Some tax-deductible interest must be claimed as an adjustment to income, and this is much more advantageous. You can claim adjustments to income regardless if you claim the standard deduction or itemize. 

The interest you paid subtracts from your taxable income whether it’s an itemized deduction or an adjustment to income. Both directly reduce your tax threshold.

Tax-Deductible Interest vs. Tax Credits

Some interest-related tax breaks are credits, not deductions. A mortgage interest credit is available if you’ve received a mortgage credit certificate (MCC) from a state or local government. Deductions—either itemized or adjustments to income—are not the same as tax credits. 

Tax credits are certain dollar amounts that come off your tax bill to the IRS after you complete your tax return.  

Types of Tax-Deductible Interest

A few types of tax-deductible interest are more commonly claimed than others. This list is not all-inclusive. Check with a tax professional if you're paying interest on a loan that falls into another category. 

Home Mortgage Interest

Numerous rules apply to the home mortgage interest deduction. You can claim the interest you're paying on the mortgage that's secured by your main home, defined by the IRS as where you live “most” of the time. It must have sleeping, cooking, and toilet areas, but there are otherwise no restrictions on the type of dwelling that qualifies. It can be a single-family home, a condo, a trailer, even a boat—as long as you can sleep, cook, and use the toilet there.

In most cases, you can deduct all of your home mortgage interest; the allowable amount is ultimately based on the date of the mortgage, the amount, and how you use the mortgage proceeds.

  • You can claim all of the interest if you purchased the home on or before Oct. 13, 1987 (referred to as “grandfathered debt”).
  • Your deduction is limited to interest associated with $1 million or less of indebtedness to buy, build, or improve your home if you took out the loan after Oct. 13, 1987, and prior to Dec. 16, 2017. This drops to $500,000 if you’re married and filing a separate return. 
  • It’s limited to loans of $750,000 for the same nature taken out after Dec. 15, 2017. This drops to $375,000 if you’re married and filing a separate return. 

These limits apply to all your mortgages collectively if you have more than one.  

You can also claim tax-deductible interest on a mortgage that’s secured by a second home, even if you don’t spend any time there. But the rules become much more complex if you rent it out at any point. In this case, you do have to reside there for at least 14 days out of the year, or for more than 10% of the time, it was rented.

You can deduct mortgage points as well, but only if you’re the buyer in the transaction. Interest associated with home equity loans may or may not be deductible. It depends on how you spend the money. It’s deductible if you take out the loan to “buy, build, or substantially improve” the home or another dwelling. It’s not deductible if you use the money for personal reasons, such as to fund your wedding.

Special rules apply if you use any portion of your home for business purposes, such as if you maintain a home office.

Student Loan Interest  

This one is an adjustment to income. You can claim interest you paid on student loans before you subtract the total of your itemized deductions or the standard deduction for your filing status. You can claim interest paid up to $2,500 for the year, or the amount you paid, whichever is less. Your adjustment to income would be $2,000, not $2,500, if that’s the amount you paid in interest.

Your student loan must be “qualified.” You won’t be able to claim the adjustment to income if you earn too much—it begins to phase out and becomes unavailable entirely when your income reaches a limit that’s dictated by your filing status. The loan must be in your name, and you can’t be claimed as a dependent on anyone else’s tax return, such as your parents. 

You will be unable to deduct student loan interest if your filing status is married filing separately.

Investment Interest 

You can deduct interest that’s associated with money you borrowed to invest up to the net amount of investment income you received in the tax year. "Net" means the balance left after you’ve subtracted other tax-deductible expenses.

This interest includes that which is associated with margin loans within your brokerage account. Deduct interest that’s charged to you or paid by you during the tax year, not necessarily in the year you incur it. 

You can carry forward to the next or subsequent tax year any portion of your interest deduction that exceeds your net investment income in the present year.

How To Claim Tax-Deductible Interest

You might want to consult with a tax professional, or at the very least use reputable tax preparation software, if you think you qualify to claim any of these tax-deductible interest expenses. Each of them comes with its own filing requirements. 

Mortgage interest and investment interest are itemized deductions. This means reporting them on Schedule A and submitting the schedule with your tax return. In this case, you are unable to  claim the standard deduction.

The total amount of mortgage interest you paid during the year will appear on Form 1098, which your lender should send to both you and the IRS after year’s end. Use Form 4952 to calculate your investment interest deduction, and submit it with your tax return. 

Adjustments to income are reported on Schedule 1, which also must accompany your tax return. You would claim your student loan interest deduction on this form. You (and the IRS) should receive Form 1098-E from your lender after year’s end, showing how much interest you paid.  

Key Takeaways

  • Tax-deductible interest is the interest you’ve paid for various purposes that can be subtracted from your income to reduce your taxable income. 
  • Not all interest is tax-deductible, including that which is associated with credit cards and auto loans.
  • Common deductible interest includes that incurred by mortgages, student loans, and investments.
  • Tax-deductible interest might be an adjustment to income, or it can be an itemized deduction, depending on the type of loan.