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.

Because of the variety of limits imposed on interest deductions, the IRS provides special rules to allocate interest expense among 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.  Also, after borrowed funds are redeployed, the subsequent use of the funds, not the original use, will determine the character of the interest expense treatment.

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.

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.

Practical Examples

Example 1: 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, by default you 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.

However, an election can be made to choose to treat any debt secured by your qualified home as not secured by your home.  This treatment begins with the tax year for which you make the election and continues for all later tax years.  You may want to treat the debt as not secured by your home if the interest on that debt is fully deductible as a business expense whether or not it qualifies as home mortgage interest.

IRS’s tracing rules remain simple as long as you keep the proceeds of a loan separate.

Example 2: 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 3: 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.

If you have questions or need assistance with your interest expense deductions, please contact your Wegner CPAs tax advisor.