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Chapter 24. Interest Expense

Personal interest. Personal interest is no longer deductible. Personal
interest includes interest charged on credit cards, car loans, and
installment plans.

Mortgage interest statement. The Form 1098, Mortgage Interest Statement, you
receive will include the amount of points you paid on most mortgages closed
after 1990.

Limit on itemized deductions. Certain itemized deductions (including home
mortgage interest) are limited if your adjusted gross income is more than
$105,250 ($52,625 if you are married filing a separate return). For more
information, see Chapter 21.

Important Reminder

Home mortgage interest. Home mortgage interest is fully deductible if certain
requirements are met. See Home Mortgage Interest, later.

Introduction

This chapter discusses:

∙  How to treat home mortgage interest,

∙  When interest expense is not deductible, and

∙  Where to deduct interest.

This chapter discusses home mortgage interest and points that you deduct on
Schedule A (Form 1040). Business interest is deducted on Schedules C, E, or F
of Form 1040.

Investment interest, although deducted on Schedule A, is subject to different
rules. These rules are discussed in Chapter 3 of Publication 550, Investment
Income and Expenses.

If you apply the proceeds of a debt to more than one use (for example,
investment and business), you have to allocate the interest on the debt
to each use in figuring how and where it is deducted. See Chapter 6 of
Publication 535, Business Expenses, for more information.

Related publications and forms.

This chapter refers to several publications and forms that you may need.
The list of forms does not include Forms 1040, 1040A, or 1040EZ. For more
information, you may want to order the following:

    Publication 535, Business Expenses

    Publication 550, Investment Income and Expenses

    Publication 936, Home Mortgage Interest Deduction

    Form 1098, Mortgage Interest Statement

    Form 8396, Mortgage Interest Credit

General Rules

Interest is an amount paid for the use of borrowed money.

To be deductible, the interest you pay must reflect the true (economic) cost
of the indebtedness for the payment period. This chapter, except where noted,
assumes that interest paid is the true cost.

Legally liable. To deduct interest on a debt, you must be legally liable for
that debt. You cannot deduct payments you make for someone else if you are
not legally liable to make them. Both the lender and the borrower must intend
that the loan be repaid. In addition, there must be a true debtor-creditor
relationship between the lender and the borrower.

Interest paid in advance. If you pay interest for a period that goes beyond
the end of the tax year, you must spread this interest paid in advance over
the tax years to which it applies. You can deduct in each year only the
interest for that year. However, see Points, later.

Refunds of interest. If you receive a refund of interest in the same tax year
you pay 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. But
you only need to include the amount of the deduction that reduced your tax in
the earlier year.

For more information, see Recoveries in Chapter 13.

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). These loans include: a mortgage,
a second mortgage, a line of credit, and a home equity loan. Provided the
interest is deductible home mortgage interest, you may deduct it on Schedule
A (Form 1040).

Limit on the Deduction of Mortgage Interest

In most cases, you will be able to deduct all of your home mortgage interest.
Whether it is all deductible depends on the date you took out the mortgage,
the amount of the mortgage, and your use of its proceeds.

If all of your mortgages fit into one or more of the following categories,
you can deduct ALL of the interest on those mortgages. (If one or more of your
mortgages is not described below, get Publication 936 to figure the amount of
interest you can deduct.)

∙  Mortgages you took out on or before October 13, 1987 (called
   grandfathered debt).

∙  Mortgages you took out after October 13, 1987, to buy, build, or improve
   your home (called home acquisition debt), but only if these mortgages
   plus any grandfathered debt totaled $1 million or less throughout 1992.

∙  Mortgages you took out after October 13, 1987, other than to buy, build,
   or improve your home (called home equity debt), but only if these
   mortgages totaled $100,000 or less throughout 1992.

If you are married and file a separate return, the home acquisition debt limit
is $500,000 and the home equity debt limit is $50,000.

Note. You cannot deduct this interest if you use the proceeds of the mortgage
to receive tax-free income.

You can use the flowchart, Is My Interest Fully Deductible? to check whether
your interest is fully deductible. If it is fully deductible, you will not
need to use the worksheets in Publication 936.

Determining Mortgages

To determine how to treat your mortgages, refer to the explanations of
mortgages, earlier. Remember that grandfathered mortgages were taken out on
or before October 13, 1987, and that home acquisition and home equity mortgages
were taken out after October 13, 1987.

Refinanced grandfathered debt. If you refinance grandfathered debt after
October 13, 1987, for an amount that is not more than the mortgage principal
left on the debt, then you still treat it as grandfathered debt. However,
any amount that is more than that mortgage principal is treated as home
acquisition or home equity debt, and the mortgage is a mixed-use mortgage
(discussed later). The debt must be secured by the qualified home.

You treat the refinanced debt as grandfathered debt only for the term left on
the original mortgage. After that, you treat it as home acquisition debt or
home equity debt, depending on how you used the proceeds. If the principal on
the original mortgage is not amortized over its term, like a balloon note,
then you treat the refinanced debt as grandfathered debt for the term of
the first refinancing. This term cannot be more than 30 years.

Line-of-credit mortgages. If you had a line-of-credit mortgage on your home on
October 13, 1987, and you borrowed additional amounts on this line of credit
after that date, the additional amounts you borrowed are treated as home
acquisition or home equity debt (or both if a mixed-use mortgage, discussed
next).

Mixed-use mortgages. If you took out a mortgage after October 13, 1987, and
used part of it to refinance a home acquisition debt or to make substantial
improvements and part of it for other purposes, it is a mixed-use mortgage.

Example. Sharon took out a mortgage on her home for $200,000 in 1980. She
files as single for 1992. In March 1992, when the home had a fair market value
of $400,000, and she owed $187,000 on the mortgage, she took out a home equity
loan for $120,000. Sharon used $90,000 of the home equity loan proceeds for
home improvements, and $30,000 for other purposes. She can deduct all of the
interest on both mortgages. The first mortgage qualifies because it was taken
out on or before October 13, 1987. The home equity loan qualifies under the
dollar limits of both home acquisition and home equity debt described above.
The part of the mortgage subject to the home acquisition debt dollar limit
($90,000) plus the first mortgage of $187,000 totaled less than the $1 million
limit. The part of the mortgage subject to the home equity debt dollar limit
($30,000) was less than the $100,000 limit.

Note. Additional limits apply if the total amount of all mortgages exceeds the
fair market value of the home. For more information, get Publication 936.

More than one home. If you had a main home and a second home, the home
acquisition and home equity debt dollar limits explained above apply to the
total mortgages on both homes. Your main home is the property you live in most
of the time. It may be a house, condominium, cooperative, mobile home, boat,
or similar property. It must provide basic living accommodations including
sleeping space, toilet, and cooking facilities. Your second home is similar
property that you select to be your second home.

Mortgage Interest Statement

If you paid mortgage interest of $600 or more during the year on any one
mortgage, you may receive a Form 1098, Mortgage Interest Statement, or
a similar statement. 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 will show the total interest you paid during the year. If you
purchase a main home after 1990, it will also show the deductible points you
paid during the year. However, it should not show other prepaid interest,
seller payments on a "buy-down" mortgage, or HUD payments under section 235 of
the National Housing Act.

Note.

Form 1098 will not include points paid for:

1)  Home improvement loans on your main home,

2)  Purchase or home improvement loans on your second home, vacation
    property, investment property, or trade or business property,

3)  Refinancing, home equity loans, and lines of credit secured by your main
    home,

4)  Amounts in excess of the points generally charged in your area, and

5)  Financing provided for closings before January 1, 1991.

See Points, later, for more information.

You should receive the statement by January 31, 1993. The mortgage interest
information will also be sent to the IRS. If the mortgage interest is fully
deductible home mortgage interest, deduct the interest and the points reported
to you on Form 1098 on Schedule A (Form 1040). See Where to Deduct, later.

If the mortgage interest is not fully deductible home mortgage interest
because you used the proceeds of the loan for other purposes, then you may
be able to deduct it as investment, business, or passive activity interest,
subject to the rules for those deductions.

If your home mortgage interest payments are more than the amount shown on the
mortgage interest statement, you can deduct the amount of the interest that
you actually paid. (However, you must meet the limits discussed earlier.)
The interest must be for the tax year you are claiming the deduction.

For example, your mortgage payments are due on the first of the month.
Therefore, if you make a January 1 mortgage payment in December of the year
before, the interest on the January payment is for December (of the year
before) and is deductible in the year paid. You must attach a statement to
your tax return explaining this difference.

You can deduct only your share of the mortgage interest you paid. If your
mortgage payments were subsidized by a government agency, do not deduct the
amount paid for you.

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 the Form 1098, attach a statement
to your return showing the name and address of that person. In the far left
margin, next to line 9b, Schedule A, write "see attached."

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, you must furnish the other borrowers with information about the
proper distribution of the amounts shown on the form you received.

Points

The term "points" is sometimes used to describe certain charges paid by a
borrower to secure a home mortgage. They are also called loan origination
fees, maximum loan charges, or premium charges. If the payment of any of
these charges by a borrower is only for the use of money, it is interest.

These points are interest paid in advance and you cannot deduct the full
amount for points in the year paid. The interest paid as points must be spread
over the life (term) of the mortgage. An equal portion is then deducted in
each year of the mortgage.

Points paid on a mortgage that exceeds the limits, discussed earlier, must be
allocated (see Publication 936).

Exception. You can deduct the amount you pay as points in 1992 if the loan is
used to buy or improve your main home and is secured by that home. In
addition, all of the following must exist:

1)  The payment of points is an established business practice in the area
    where the loan was made,

2)  The points paid did not exceed the number of points generally charged in
    this area, and

3)  If the loan was used to improve your main home, the points are paid with
    funds other than those obtained from your lender.

If the loan was used to buy your main home, you must have provided funds at
the time of closing at least equal to the points charged. Funds you provided
include down payments, escrow deposits, earnest money applied at the closing,
and funds actually paid at closing.

You can use the flowchart Are My Points Fully Deductible This Year? as a
quick check to see if the points you paid in 1992 fit this exception.

Excess points. If you paid more points than generally paid in this area, your
deduction is limited to the points generally charged. Any additional amount of
points you paid is interest paid in advance and the deduction must be spread
over the life of the mortgage.

Second home. This exception does not apply to points you pay on loans secured
by your second home. You can only deduct these points over the life of the
loan.

Refinancing. Points you pay to refinance a mortgage are not deductible in
full in the year you pay them unless they are paid in connection with the
improvement of a home. This is true even if the new mortgage is secured by
your main home.

For more information on refinancing, see Publication 936, Home Mortgage
Interest Deduction.

Points charged for specific services by the lender for the borrower's account
are not interest. Examples of fees for services not considered interest are
the lender's appraisal fee, preparation costs for the mortgage note or deed
of trust, settlement fees, and notary fees. Points charged for services
for getting a Department of Veterans Affairs (VA) or Federal Housing
Administration (FHA) loan are not interest.

Expenses you pay in connection with a mortgage, such as commissions, abstract
fees, and recording fees, are capital expenses. You cannot deduct these
expenses either as interest or as current business expenses. Add these to
the basis of the property.

Example. Jan Green got a loan from a bank to buy her home. The loan was
guaranteed by the VA. Jan paid the bank a loan origination fee. The fee was 1%
of the amount of the loan. It was charged in addition to the maximum rate of
interest permitted on VA loans. The 1% loan origination fee (one point) is
not interest. Jan cannot deduct it.

Points paid by a seller. The term "points" also is used to describe loan
placement fees that the seller may have to pay to the lender to arrange
financing for the buyer. The seller cannot deduct these amounts as interest.
But these charges are a selling expense that reduce the amount realized.
See Chapter 16 for information on selling your home.

Special Rules

This section contains other information you may need to know about home
mortgage interest.

Sale of home. If you sell your home, you can deduct the interest paid up to,
but not including, the date of sale.

Example. John and Peggy Harris bought a new home on May 3. They sold their
old home on May 6. During the year they made deductible home mortgage interest
payments of $122 on the old home and $2,864 on the new home. The settlement
sheet for the sale of the old home showed $4 interest for the 5─day period
in May up to, but not including, the date of sale. Their mortgage interest
deduction for the year is $2,990 ($122 + $2,864 + $4).

Late payment charge on mortgage payment. You can fully deduct a late payment
charge if it was not for a specific service performed by your mortgage holder
and it was deductible home mortgage interest.

Mortgage interest credit. If you are the holder of a qualified mortgage
credit certificate that provides financing for the acquisition, qualified
rehabilitation, or qualified home improvement of your main home, you may be
able to take a mortgage interest credit. This credit is figured 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 information
on how to figure the credit, see Chapter 36.

Example. The mortgage interest paid on the loan amount shown on your mortgage
credit certificate and Form 1098 is $3,900. Your certificate credit rate
is 30%. You reduce your mortgage interest by $1,170 ($3,900 * 30%), your
allowable credit, and deduct $2,730 ($3,900 - $1,170) on line 9a, Schedule
A (Form 1040).

Ministers' and military housing allowance. If you are a minister or member of
the uniformed services and receive a housing allowance that you can exclude
from income, you can still deduct all of the deductible interest on your home
mortgage.

Graduated payment mortgages (GPM). GPMs under section 245 of the National
Housing Act provide that monthly payments increase every year for a number of
years and then stay the same. During the early years, payments are less than
the amount of interest owed on the loan. The interest that is not paid becomes
part of the principal. Future interest is figured on the increased unpaid
mortgage loan balance.

Subject to the applicable limits, you can deduct the interest you actually
paid during the year if you are a cash method taxpayer. For example, if the
interest owed is $2,551 but your payment for the year is $2,517, you can
deduct $2,517. Add $34 to the loan principal.

Mortgage assistance payments. If you qualify for mortgage assistance payments
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 any interest that is paid
for you. You do not include these payments in your income. However, these
payments do not reduce other deductions, such as taxes.

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 terminate the lease and to buy the lessor's entire
interest in the land are not ground rents. You cannot deduct them. For
more information, see Publication 936.

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

Rental payments. If you live in a house before your final settlement,
any payments you make for that period are rent, not interest, even if
the settlement papers call them interest. You cannot deduct these payments.

Reverse mortgage loans. A reverse mortgage loan is a loan that is based on
the value of your home and is secured by a mortgage on your home. The lending
institution pays you the proceeds of the loan in installments over a period of
months or years. The loan agreement may provide that interest will be added to
the outstanding loan balance monthly as it accrues. If you are a cash method
taxpayer, you deduct the interest on a reverse mortgage loan when you actually
pay it, not when it is added to the outstanding loan balance.

Mortgage prepayment penalty. If you pay off your mortgage early, you may have
to pay a penalty. You can deduct that penalty as deductible home mortgage
interest if it qualifies. If the proceeds of the loan were used for business
or investment purposes, you may be able to deduct it under the rules for those
expenses.

Items You Cannot Deduct

Some interest payments are not deductible. Certain expenses similar to
interest also are not deductible. These items include:

∙  Personal interest

∙  "Points" if you are a seller

∙  Nonredeemable ground rent

∙  Service charges (however, see List of Other Expenses in Chapter 30)

∙  Annual fees for credit cards

∙  Loan fees

∙  Credit investigation fees

∙  Interest relating to tax-exempt income

∙  Interest to purchase or carry tax-exempt securities

∙  Interest to purchase or carry certain straddle positions

∙  Premium on a convertible bond

Interest to purchase or carry tax-exempt securities. You cannot deduct
interest on money you borrow to buy tax-exempt securities. See Publication
550.

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.

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

Personal Interest

You can no longer deduct any personal interest you pay. Personal interest is
any interest that is not home mortgage interest, investment interest, or
business interest.

Personal interest includes such items as:

∙  Interest on car loans,

∙  Interest on income tax,

∙  Installment plan interest,

∙  Credit card finance charges,

∙  Retail installment contract finance charges,

∙  Revolving charge account finance charges,

∙  Late payment charge by a public utility, and

∙  Interest on certain gift and demand loans (see Chapter 1 of Publication
   550).

Allocation of Interest

If the proceeds of a loan are applied to mixed uses, an allocation must
generally be made to determine the amount of interest for each category.
However, do not allocate home mortgage interest that 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 to specific uses. For details on how to do this, see
Chapter 6 of Publication 535, Business Expenses.

Where to Deduct

You must file Form 1040 to deduct any interest expense on your tax return.
Where you deduct your interest expense generally depends on how you use the
loan proceeds.

Home mortgage interest and points. Deduct fully deductible home mortgage
interest and points reported to you on Form 1098 on line 9a of Schedule A
(Form 1040).

Deduct fully deductible home mortgage interest that was not reported to you on
Form 1098 on line 9b of Schedule A (Form 1040). If the interest was paid to an
individual, list the person's name and address in the space provided.

Deduct points paid on a mortgage that were not reported to you on Form 1098 on
line 10, of Schedule A (Form 1040).

Investment interest. Deduct investment interest, subject to certain limits
discussed in Publication 550, on line 11, Schedule A (Form 1040).

Non-farm business interest. Deduct interest on non-farm business loans on
Schedule C (Form 1040).

Farm business interest. Deduct interest on farm business loans on Schedule F
(Form 1040).

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.