Not all types of interest payments are deductible, and the interest tracing rules for deducting interest depend on the purpose of the loan—whether it’s for personal, investment, or business use. You must follow the loan proceeds to what they were used for in order to determine the purpose.
Interest expenses can fall into the following categories:
Personal Interest: This type is not deductible.
Investment Interest: This refers to interest on debt used to acquire property held for investment. The annual deduction is limited to your “net investment income.”
Residence Interest: This is the interest on a home mortgage, including a second home, which is generally deductible as an itemized deduction.
Passive Activity Interest: This is interest on debt used for business or income-producing activities in which you do not “materially participate.” It is deductible only if income from these passive activities exceeds the related expenses.
Trade or Business Interest: This is interest on debt used for activities in which you do materially participate. It is usually fully deductible.
Please note: “Portfolio interest” is another category not covered here. Also, there are several limitation areas not covered in this article, including the 163(j) limitations on deducting business interest expense which generally limits interest to 30% of a taxpayer’s adjusted taxable income. Due to the varying limits on interest deductions, the IRS has established special “tracing rules” to allocate interest expenses according to the use of the loan proceeds.
According to these rules, interest is allocated based on how the debt proceeds are used. The loan proceeds are traced to specific expenditures to determine the category of interest expense.
The property securing the loan generally does not affect the interest treatment; it is the use of the proceeds that matters.
Example: If you take out a loan secured by business property but use the proceeds to buy a personal car, the interest must be allocated to personal use (the car purchase) and is therefore not deductible.
However, if a loan is secured by your home, you typically do not need to allocate the loan proceeds or the interest. Interest on a mortgage 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. Interest on a home equity loan up to $100,000 is also deductible for tax years after 2025 and before 2018, regardless of use, though this deduction is not available for 2018–2025.
The tracing rules are straightforward if you keep loan proceeds separate.
Example: If you borrow $100,000 for your consulting business and deposit it into a dedicated business account, the interest on this loan is classified as trade or business interest.
Example: If you borrow $20,000 through a margin account and use it solely to purchase securities, the interest is classified as investment interest.
The rules become more complex if you combine funds from multiple loans or non-loan amounts into a single account for various expenditures. Detailed ordering rules determine how debt is matched with expenditures. Generally, funds from the earliest loan are considered used first, but expenditures made within 30 days before or after a deposit can be attributed to that deposit.
To simplify, consider maintaining separate accounts for each loan.
