Interest is an amount you pay for the use of borrowed money. To deduct interest you paid on a debt you must be legally liable for the debt. There must be a true debtor-creditor relationship. Additionally you generally must itemize your deductions unless the interest is on rental or business property or on a student loan.
If you prepay interest you must allocate the interest over the tax years to which it applies. You may deduct in each year only the interest that applies to that year. However there is an exception that applies to points paid on a principal residence.
Types of interest you can deduct as itemized deductions on Schedule A include investment interest (limited to your net investment income) and qualified residence interest. You cannot deduct personal interest. Personal interest includes interest paid on a loan to purchase a car for personal use. Personal interest also includes credit card and installment interest incurred for personal expenses. Items you cannot deduct as interest include points (if you are a seller) service charges credit investigation fees and interest relating to tax-exempt income such as interest to purchase or carry tax-exempt securities.
You can deduct student loan interest on front page of the 1040. Generally the amount you may deduct is the lesser of $2500 or the amount of interest you actually paid.
Qualified residence interest is interest you pay on a loan secured by your main home or a second home. Your main home is where you live most of the time. It can be a house cooperative apartment condominium mobile home house trailer or houseboat that has sleeping cooking and toilet facilities.
A second home can include any other residence you own and treat as a second home. You do not have to use the home during the year. However if you rent it to others you must also use it as a home during the year for more than the greater of 14 days or 10 percent of the number of days you rent it for the interest to qualify as qualified residence interest.
Qualified residence interest and points are generally reported to you on Form 1098 (PDF)Mortgage Interest Statement by the financial institution to which you made the payments. The following mortgages yield qualified residence interest and you can deduct all of the interest on these mortgages:
· A mortgage you took out on or before October 13 1987 (grandfathered debt)
· A mortgage taken out after October 13 1987 to buy build or improve your home (called home acquisition debt) up to a total of $1 million for this debt plus any grandfathered debt. The limit is $500000 if you are married filing separately.
· Home equity debt other than home acquisition debt taken out after October 13 1987 up to a total of $100000. The limit is $50000 if you are married filing separately. Home equity debt other than home acquisition debt is further limited to your home’s fair market value reduced by the grandfathered debt and home acquisition debt.
You may be able to take a credit against your federal income tax if you were issued a mortgage credit certificate by a state or local government for low income housing.
You may be subject to a limit (phase-out) on some of your itemized deductions including mortgage interest.
Itemized deductions such as Interest expense can be key in lowering your tax liability.