Debt and Your Taxes

Updated on January 20, 2009.

THEY'RE BOTH TOO HIGH, right? But your debts may actually help keep the evil twin at bay. Why? Some of that interest you shovel out each month is tax-deductible. Back in "the good old days," taxpayers were allowed to deduct all their interest charges, even credit-card bills for vacations, Armani suits and movie tickets. Then, Congress caught on.

Now the Tax Code permits deductions only for certain varieties of interest. This makes debt management more important than ever, because you are basically penalized by the IRS whenever you have interest that falls into the nondeductible category. Here's a quick summary on when you get a tax break for borrowing and when you don't.

Home-Mortgage Interest
You are allowed an itemized deduction for interest on up to $1 million worth of mortgages used to acquire or improve your main personal residence and one other home. Mortgage interest on your third personal residence and beyond is considered a nondeductible personal expense.

So the tax-wise debt-management trick here is to: (1) make sure you don't have over $1 million in mortgage debt and (2) pay cash for your third, fourth and fifth homes. We should all have such financial challenges.

Watch out if you have a high income. Up to 26.7% of your hoped-for 2009 home-mortgage-interest writeoff may be "phased out" when you put pencil to paper at tax time. For 2009, phase-out begins when adjusted gross income (AGI) exceeds $166,800, or $83,400 if you are married and file a separate return. Bottom line: people who earn big bucks lose a good chunk of the mortgage interest tax subsidiary us regular folks take for granted. So paying cash for one's palatial abode makes sense tax-wise when one makes lots of dough.

Interest on Home-Equity Loan
You are also allowed to claim an itemized deduction for interest on home-equity loans totaling up to $100,000, regardless of how you use the loan proceeds. The $100,000 figure is above and beyond the $1 million limit explained above. So you can actually have up to $1.1 million of debt against your first and second homes and still deduct the interest.

Two warnings here. First, the home-equity debt, when piled on top of your "regular" mortgage, cannot exceed the fair market value of the property at the time you take out the loan. For example, say your first mortgage is $150,000 and your casa is worth $225,000. You may be able to get a $100,000 home-equity loan, but you can only deduct the interest on $75,000.

Second, interest on home-equity loans is deductible for alternative minimum tax (AMT) purposes only if you use the proceeds to acquire, construct or improve a first or second residence. So if you are in the AMT mode, you should understand that you may not get any tax benefit if you take out a $50,000 home-equity loan to buy a new BMW and pay for your kid's braces. On the other hand, if you spend the $50,000 to put in a deluxe swimming pool and spa alongside your house, you can deduct the interest under both the regular tax and AMT rules. Does this make any sense? Of course not, but Congress doesn't ask for my input on tax legislation.

Interest on Vacation Homes
For most people, the vacation home is the second home and the mortgage interest will turn out to be deductible under the rules explained earlier. However, when you rent the property part of the time, the tax rules get very tricky. Nevertheless, you will usually be able to deduct all of the interest or nearly so. For the sordid details, see "Taxes on Vacation Homes."

Investment Interest
When you borrow money and use the proceeds to buy taxable investment assets, the resulting interest is called investment-interest expense. The most common example: interest on broker-margin accounts.

You can deduct investment interest to the extent of your taxable investment income — from interest, short-term capital gains, certain royalties and the like. If you don't have enough investment income, the excess interest expense gets carried over to the following tax year. Hopefully, you'll have enough investment income in that year to claim your writeoff. If not, the carryover procedure happens all over again. And so on and so on.

You can also choose to treat all or part of your long-term capital gains and qualified dividends as investment income. The upside of making this choice is it allows you to currently deduct more of your investment-interest expense. The downside is the amount of long-term gains and dividends treated as investment income gets taxed at your regular rate instead of the normal 15% or less.

If you have investment interest, complete IRS Form 4952 (Investment Interest Expense Deduction) to calculate your writeoff. You also use this form to indicate how much of your long-term capital gains and qualified dividends, if any, you want treated as investment income.

What about interest on loans used to purchase nontaxable investments, like municipal bonds or muni-bond funds? Nondeductible. Logically enough, the government won't let you write off interest on debts used to generate income that goes untaxed.

So if your investing strategy calls for some borrowing, the tax-wise trick is to spend the debt proceeds to buy taxable investments and use cash to pay for the nontaxable ones.

College-Loan Interest
Not too long ago, Congress finally gave us a much-needed tax break for interest on loans used to pay for college. But it comes with limitations, and high-income types won't be eligible (surprise). Check out "College Tax Breaks Explained" for more. If you fall into the ineligible category, consider taking out a home-equity loan instead. You have a decent shot at being able to deduct the interest, as explained above.

Interest on 401(k) Loans
This is generally nondeductible regardless of how you use the money. Sorry. But this is not really so bad, because you are basically paying interest to yourself. The potential downside of tapping this particular line of credit is that you must immediately repay the loan if you leave the company. If you don't, you'll be taxed as if you received a distribution equal to the loan balance. When this happens before age 59 1/2, you will generally be tagged with a 10% penalty tax to boot. So you generally shouldn't even think about taking out a 401(k) loan unless you are darn sure you'll be able to pay it back on time and in full.

Interest on Car Loans, Credit Cards and Other 'Consumer Debt'
Unless you are borrowing to finance a business expenditure — like a car used in your sole-proprietorship business — you can generally forget about any tax breaks.

This is why it's often advisable to take out a home-equity loan and use the money to pay off credit-card balances and car loans. You may be able to convert high nondeductible interest charges into relatively low interest charges that are fully deductible. If so, this procedure is an excellent debt-management scheme. Just make sure you read the earlier caveats about the deductibility issue.

Business Interest
What happens when you borrow money and use it to finance your small business? The interest is generally fully deductible just like any other garden-variety business expense. Before you jump for joy at the apparent simplicity of the preceding sentence, be warned that the IRS has a complicated set of rules which basically require you to trace the debt proceeds to business uses. If this affects you, be sure to schedule a chat with your tax accountant to talk about what exactly is needed to lock in your writeoffs.