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Four Ways to Deduct Interest Expenses

There are four basic categories of interest expenses you can deduct on your tax return: personal interest, mortgage interest, investment interest and business interest. The following are the key rules for taxpayers to focus on during tax return season. 

1. Personal interest: If an interest expense does not fall into one of the other categories, it is treated as personal interest. Simply put, personal interest is nondeductible. However, there is one limited exception for interest paid on student loans. In brief, you can claim a limited deduction for interest paid for qualified higher education expenses-such as tuition, room and board, and books and fees-if the loan is in your name. The maximum deduction of $2,500 is phased out for high-income taxpayers.

2. Mortgage interest: As a general rule, you can deduct "qualified residence interest" paid during the year. To qualify, you must be legally obligated to pay the mortgage and the mortgage must be secured by a qualified home (i.e., your principal residence and one other home). The deduction limit depends on whether the debt is an acquisition debt or a home equity debt.

*Acquisition debt: This is a debt incurred to buy, build or improve a qualified home. The interest paid on up to $1 million of acquisition debt is fully deductible.

*Home equity debt: Any other qualified debt, such as a home equity loan or line of credit, is treated as a home equity debt. The interest paid on up to $100,000 of home equity debt is fully deductible.

Unlike most other types of interest expenses, the interest on home equity debt may be deducted no matter how the loan proceeds are used. Home equity debt cannot exceed the fair-market value of the home on the last day of the year reduced by the outstanding acquisition debt.

3. Investment interest: If you borrow funds to buy property held for investment purposes (e.g., securities or real estate), the interest paid on the loan is treated as investment interest. The amount of investment interest you can deduct is generally limited to the amount of your "net investment income" for the year. Any excess is carried over to the next year.

Net investment income includes gross income from property held for investment such as interest, annuities and royalties. It does not include capital gains and qualified dividends eligible for tax-favored treatment. The maximum tax rate for long-term capital gain and qualified dividends is only 15% as opposed to ordinary income taxed as high as 35%. However, you can elect to include long-term capital gain and qualified dividends as net investment income if you are willing to forfeit the preferential tax rate.

4. Business interest: The interest incurred in a trade or business or in the production of rental or royalty income is fully deductible. That is pretty straightforward. Unlike the deductions for mortgage interest and investment interest, there are no limits on deductible amounts.

Nevertheless, there are a few other wrinkles in the tax law. Be aware that interest expenses on the following types of loans generally do not constitute business interest.

*Loans to buy a business: The interest paid on a loan to buy stock in a C corporation is considered investment interest. If you acquire an S corporation or other pass-through entity, however, you can generally deduct the interest as business interest.

*Retirement plan loans: If you borrow from a qualified retirement plan and use the funds for your business, the interest paid back to the plan is nondeductible even if the funds are used for business purposes.

*Tax payments: If you charge business income tax payments on your credit card, the interest is deductible only if you own a C corporation.

*Construction loans: Interest incurred to construct business property-for instance, an office building or a factory-must be capitalized as a construction cost. The interest is amortized and deducted over the life of the property.

We can help you maximize your interest deductions on your 2005 tax return. Do not hesitate to contact our office for assistance.

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