“Tracing Rules” that Apply for Deductibility of Interest
Often times, we get asked whether certain interest that clients paid during the year is deductible on their income tax return. Unfortunately, not all interest that an individual pays is deductible. The rules for deducting interest vary, depending on whether the loan proceeds are used for personal, investment, or business activities. Interest expense can fall into any of the following categories:
- Personal interest, which isn't deductible.
- Investment interest (interest on debt that's for property held for investment), for which the yearly deduction is limited to “net investment income.”
- Residence interest (interest on a home mortgage), which is generally deductible as an itemized deduction.
- Passive activity interest (interest on debt that's for business or income-producing activities in which you don't “materially participate”), which is generally deductible only if income from passive activities exceeds expenses from those activities.
- Trade or business interest (interest on debt that's for activities in which you do materially participate), which you can generally deduct in full.
Because of the variety of limits imposed on interest deductions, the IRS provides special rules to allocate interest expense among the categories. These “tracing rules,” as they are called, are generally based on the use of the loan proceeds.
Under the tracing rules, interest expense is allocated in the same way as the debt on which the interest is paid. The debt, in turn, is allocated by tracing payouts of the debt proceeds to specific expenditures. The property that secures the loan generally won't affect the way the interest is treated. It's the use of the proceeds that counts.
Example: You take out a loan secured by property used in your business, but use the loan proceeds to buy a car for personal use. You must allocate interest expense on the loan to personal use (purchase of the car) even though the loan is secured by business property. So that interest isn't deductible.
But if a loan is secured by your home, you generally don't have to allocate the loan proceeds or the interest. The interest on a mortgage loan of up to $750,000 ($1 million for tax years after 2025 and before 2018) is deductible if used to buy, build, or substantially improve your home. (The interest on a home equity loan of up to $100,000 is deductible for tax years after 2025 and before 2018 regardless of how the loan proceeds are used. However, the home equity interest deduction is disallowed for 2018–2025.)
IRS's tracing rules remain simple as long as you keep the proceeds of a loan separate.
Example: You borrow $100,000. This debt isn't secured by your home. The money is to be used in your consulting business. You deposit that $100,000 into a checking account that's devoted to your business, and you use the money in that account only for your business. So the interest you pay on that line of credit is treated as trade or business interest.
Example: You borrow $20,000 on a margin account held by your broker. The debt isn't secured by your home. You use the $20,000 only to buy securities. So the interest you pay on the margin account is treated as investment interest.
The tracing rules become more complicated when funds from several different loans and non-loan amounts are combined in a single account, from which expenditures are made for a variety of purposes. Detailed ordering rules must be applied to match debt with expenditures. For instance, when borrowed funds from several loans are deposited into an account at different times, the funds from the earliest loan are deemed to be used first. However, you can treat any expenditure you make within 30 days before or 30 days after you deposit loan proceeds in an account as being from those proceeds.
You can avoid these complications by maintaining separate accounts for separate loans.
If you would like to discuss these rules further, please contact our office: 410-792-7259.Back To List