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What interest payments are deductible?
This used to be a simple question, but since 1986, deductibility has become very complicated. The general rule is that interest is deductible, but the exceptions are almost as great as the rule.
One exception to the general rule is investment interest. Investment interest is interest on indebtedness properly allocable to property held for investment, such as stocks held on margin, loans to others, etc.
Investment interest also includes interest on real property rentals if the taxpayer actively participates in the activity. (As discussed later, passive real estate rentals are subject to a separate disallowance rule relating to passive activity losses.) Investment interest is deductible by individuals only to the extent of investment income. Investment income means interest from investment property, including net capital gains. Examples of investment income include interest received and dividends.
Personal interest is also disallowed. Personal interest is defined as all interest except trade or business interest, investment interest, qualified residence interest (discussed in the following paragraph) and interest taken into account as part of the passive activity rules. This is why it might appear that the exceptions are consuming the rule.
Qualified residence interest includes the interest on a mortgage securing a principal residence or one other residence (like a beach house or mountain cabin), the proceeds of which were used to acquire the residence. But your debt cannot exceed $1,000,000. In addition, qualified residence interest includes interest on any debt secured by a principal or the other residence, but not in excess of the fair market value of the residence less the acquisition debt. In addition, this other debt is limited to $100,000. The net result is that interest on debt secured by a qualified residence cannot exceed the value of the residence, in addition to the $1,000,000 and $100,000 limits.
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