Businesses and individuals begrudgingly pay interest, because it appears little is to be gained. This is not entirely true. Interest expense, in certain cases, is tax-deductible.
Shown on an income statement, interest expense is defined as the interest payable on any type of borrowed money, including bonds, loans, convertible debt or lines of credit. It is typically calculated as the interest rate multiplied by the outstanding principal of the debt. One of many lesser-known deductions, interest expense is the amount of yearly interest accrued not the amount of interest paid.
Individuals save by deducting interest expense
For companies, interest expense is tax-deductible. But for individuals, interest expenses are tax-deductible only for certain types of loans. In individual tax planning and preparation, it’s important to remember what interest expenses are and aren’t tax-deductible.
When itemizing, individual taxpayers may deduct:
- Investment interest
- Qualified mortgage interest, including interest points for home buyers
- Student loan interest
Individual taxpayers may not deduct personal interest, including:
- Interest paid on a car loan for personal use
- Credit card and installment interest from charges for personal expenses
- Seller’s mortgage points, service charges, credit investigation fees and interest associated with tax-exempt income
Business may deduct interest expense, too
A wider array of interest expense deductions are available to businesses. Interest paid on a business loan is a tax-deductible expense. Interest paid on bank loans, credit cards, real estate mortgages all qualify for tax deductions for businesses. Car loans, loans to buy a business and loans from family and friends are all tax-deductible.
The general rule is that if you use the money loaned for business, the interest expense may be deducted. It doesn’t matter what type of loan a business receives as long as the money is used for business functions. Annual interest for a business is deductible on an IRS Schedule C, Form 1040.
A final important rule to remember is that interest earned on money in the bank is never tax-deductible.