A common question among clients is whether the interest they paid on a loan is deductible. The answer depends on whether the loan proceeds can be traced to personal, investment or business activities. While the interest tracing rules can be complex in their application, they do allow significant flexibility to provide an opportunity for tax savings.
Prior to 1986, interest expense, regardless of type, was generally deductible. With the passing of the Tax Reform Act of 1986 (1986 TRA), personal interest expense, outside of residential interest expense, was no longer deductible, and other types of interest expense were subject to limited deductions. Following the 1986 TRA, interest tracing, the rules that determine the character of interest expense by tracing the use of the loan proceeds, was introduced.
The assets that secure or collateralize the loan do not determine the deductibility of the interest expense, but rather the actual use of the loan proceeds. Interest expense falls into one of the following five categories. Within each category, there are certain limitations that can reduce the interest deduction.
- Personal Interest – Non-deductible. Loan proceeds used to purchase goods for personal consumption.
- Investment Interest – Deductible. Loan proceeds used to purchase assets held for investment (stocks, bonds, mutual funds, art, etc.). However, if loan proceeds are used to purchase tax exempt securities, i.e., municipal bonds, the interest expense will not be deductible. To the extent loan proceeds are held in a bank account (even a non-interest checking account), it is considered invested. The ability to deduct investment interest is limited to a taxpayer’s taxable investment income (interest, ordinary dividends, realized short term capital gains, etc.). Taxpayers are able to make an election to treat qualified dividends and long term capital gains as investment income, which may be favorable depending on the taxpayer’s circumstances. Disallowed investment interest expense is carried over to future years.
- Residential Interest (Mortgage Interest) – Deductible. Loan obtained for the purchase of a residence or to perform substantial improvements to a residence. Subject to principal limit of $750,000 MFJ/$375,000 Single (2018 loans and forward) $1,000,000 MFJ /$500,000 Single (pre-2018 loans).
- Passive Interest -Deductible. Interest on debt for business or other income-producing activities in which the taxpayer does not materially participate. Subject to passive activity loss limitations. Disallowed interest is carried over to future years.
- Trade or Business Interest – Deductible. Interest on debt for activities in which the taxpayer materially participates. Subject to excess business loss limitations and certain business interest expense limitations. Disallowed interest is carried over to future years.
A key planning item that is often overlooked by taxpayers is placing loan proceeds directly into a segregated account. The commingling of loan proceeds with existing assets can result in the loss of all or some of the interest expense deduction. When loan proceeds are commingled with existing assets, the ordering rules regard loan proceeds as withdrawn first. Therefore, any withdrawals from a commingled account will be traced until the full loan proceeds are exhausted. Segregating the loan proceeds into a separate account allows the taxpayer to choose to only use the loan proceeds for uses that will provide the greatest tax benefit for the interest paid, while using other money for uses that would not allow a tax benefit for interest paid.
Categorizing interest expense and the importance of a segregated account can be demonstrated through the example below.
On January 1, a taxpayer borrows $200,000 from a bank, which is collateralized by an existing investment account the taxpayer has with the bank. The interest rate on the loan is 5%. The loan proceeds are deposited directly into an existing bank account that has $50,000 in it.
From January 1 through September 30, the full loan remains in the checking account. On October 1, the taxpayer uses $50,000 of loan proceeds to purchase a car that he uses to run his daily errands. On November 1, the taxpayer contributes $100,000 of the loan proceeds to a start-up company in exchange for a 5% interest. The taxpayer does not participate in the operations of the partnership.
How would the interest tracing rules apply to the set of events surrounding the $200,000 bank loan?
The annual loan interest is $10,000 ($200,000 x 5%) allocated among 3 categories of interest expense.
- Investment Interest: $8,535
- For the period January 1 through September 30, while the full loan proceeds are maintained in the checking account, 100% is deductible as investment interest. The total interest paid that is allocable to this period is $7,480 ($10,000 x 273 days / 365 days).
- For the period October 1 through October 31, while 75% of the loan proceeds remain in the checking account, 75% of the interest is deductible as investment interest. The total interest paid for this period is $849, of which $637 qualifies as investment interest. ($10,000 x 31days / 365 days x 75%).
- For the period November 1 through December 31, while 25% of the loan proceeds remain in the checking account, 25% of the interest is deductible as investment interest. The total interest paid for this period is $1,671, of which $418 qualifies as investment interest. ($10,000 x 61days / 365 days x 25%).
- Personal Interest Expense: $630
- For the period October 1 through October 31, while 25% of the loan proceeds are used to purchase a personal asset (car), 25% of the interest is non-deductible personal interest. The total interest paid for this period is $849, of which $212 is non-deductible personal interest. ($10,000 x 31days / 365 days x 25%).
- For the period November 1 through December 31, while 25% of the loan proceeds are traced to the purchase of a personal asset (car), 25% of the interest is non-deductible personal interest. The total interest paid for this period is $1,671, of which $418 is non-deductible personal interest. ($10,000 x 61days / 365 days x 25%).
- Passive Interest Expense: $835
- For the period November 1 through December 31, while 50% of the loan proceeds are used for a passive interest in a partnership, 50% of the interest is eligible to be deducted as passive interest. The total interest paid for this period is $1,671, of which $835 qualified as passive interest ($10,000 x 61 days / 365 days x 50%).
Planning Point: Under the ordering rules, it does not matter that the taxpayer had $50,000 in the bank account prior to the loan; the loan proceeds are considered spent first. If the loan had been placed in a segregated account, it is assumed the taxpayer would have used their existing funds to pay for the car, and therefore the full interest expense would have been eligible for deduction.
By anticipating borrowing needs and identifying asset acquisitions, a taxpayer can determine what steps they need to take to maximize their interest expense deduction. Leveraging non-income producing assets (i.e., personal or vacation homes, art, and collectibles) or income-producing assets (securities, rental real estate, investment properties, etc.) to invest in assets that are expected to yield a higher rate of return are excellent vehicles for expanding wealth. When borrowing to obtain these goals, it is optimal to seek the advice of a tax advisor that is well versed in the interest tracing rules.
Veronique Horne is a Senior Principal at Berdon LLP.