Many taxpayers are confused about whether interest paid on debts they incur is deductible for federal income tax purposes. Before 1987, personal interest such as interest on car loans, credit cards, and personal loans was fully tax deductible as an itemized deduction. Since 1991, however, personal interest has not been tax deductible at all. Nonetheless, taxpayers aware of how different forms of interest are classified in tax law can typically arrange their affairs so that most or all of the interest they pay will continue to be deductible as an itemized deduction so long as they have sufficient income and liquidity. Taxpayers unaware of the classifications often end up losing out on these deductions. This blog post describes a simple technique to turn non-deductible personal interest into deductible investment interest.
The tax law defines personal interest in a “catch-all” sense by telling us what personal interest is not, and then saying personal interest is all other interest. In other words, if the interest expense incurred doesn’t fall into another defined classification/type of interest, then it is personal interest. There are five types of interest expense other than personal interest expense enumerated in federal tax law:
- Interest paid or accrued on indebtedness allocable to a trade or business
- Investment interest
- Qualified residence interest
- Interest taken into account in computing income or loss from a passive activity
- Interest related to the payment of federal estate tax on an installment basis
So if the interest expense incurred isn’t one of these five types of interest, it is nondeductible personal interest. Each one of these classifications has its own rules and limitations. With the exception of qualified residence interest, there is a set of “tracing rules” in federal income tax law used to determine if and when interest expense incurred falls into one of the non-personal interest buckets. The basic idea of these tracing rules is that you look at how the borrowed proceeds were expended – not at the collateral that secures the loan.
For instance, if a taxpayer borrows funds and uses those funds (“traces”) for the purchase of a personal-use automobile, the interest expense incurred on the loan will be non-deductible personal interest so long as the taxpayer owns the automobile (expenditures are re-allocated when the use of the debt proceeds changes). However, if a taxpayer borrows funds and deposits the funds into a bank account, or purchases securities with the funds, the interest expense will be deductible investment interest.
The rigid, expenditure-based approach of the tracing rules allows a taxpayer wishing to purchase the personal-use automobile above to convert the interest expense incurred on a loan to purchase the automobile into investment interest, provided the taxpayer has sufficient liquidity. Rather than take out a loan and use the proceeds to purchase the automobile, the taxpayer may sell securities, and then use the proceeds of the sale to purchase the automobile. Then the taxpayer can take out a loan using the automobile as collateral for the loan, and take the proceeds of the loan and purchase securities (perhaps the same securities the taxpayer sold to get the funds for the auto purchase). Ignoring any capital gains or losses on the sale of the securities, the taxpayer in this example is in the same position as if they had used the loan proceeds to purchase the automobile directly, however, they are now incurring deductible investment interest expense as opposed to non-deductible personal interest expense.
There are a number of caveats and limitations concerning this simple example, but it does illustrate an often-used simple technique in tax planning concerning interest expense.
With sufficient planning, taxpayers in positions of adequate liquidity should rarely, if ever, be paying any non-deductible personal interest. Ensuring that this is the case is often a product of comprehensive tax planning. Comprehensive tax planning is an on-going, holistic, multi-faceted process involving many variables and trade-offs. At Levin Swedler Kennedy, we develop these plans across a broad range of taxpayers.
Written by: Brian Spencer