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Dividing Up Your Interest Expenses - How to determine tax return deductions

How do you distinguish interest expenses on your tax return? There are four main "baskets" of interest expenses for this purpose (although there are technically other categories of "interest" in the tax law). Here are the key points you should know about.
1. Personal interest: If an interest expense does not fall into one of the other three baskets, it is generally treated as personal interest. Simply put, personal interest is nondeductible. However, there is a key exception for interest paid on student loans. In brief, you can claim a limited deduction for interest paid for qualified higher education expenses-such as tuition, room and board, books and fees-if the loan is in your name. The maximum deduction of $2,500 is phased out for high-income taxpayers.
2. Mortgage interest: As a general rule, you can deduct "qualified residence interest" paid during the year. To qualify, you must be legally obligated to pay the mortgage, and the mortgage must be secured by a qualified home (i.e., your principal residence and one other home). The deduction limit depends on whether the debt is an acquisition debt or a home equity debt.
*Acquisition debt: This is a debt incurred to buy, build or improve a qualified home. The interest paid on up to $1 million of acquisition debt is fully deductible.
*Home equity debt: Any other qualified debt, such as a home equity loan or line of credit, is treated as a home equity debt. The interest paid on up to $100,000 of home equity debt is fully deductible.
Unlike most other types of interest expenses, the interest on home equity debt may be deducted no matter how the loan proceeds are used. Home equity debt cannot exceed the fair-market value of the home on the last day of the year reduced by the outstanding acquisition debt.
3. Investment interest: If you borrow funds to buy property held for investment purposes (e.g., securities or real estate), the interest paid on the loan is treated as investment interest. The amount of investment interest you can deduct is generally limited to the amount of your "net investment income" for the year. Any excess is carried over to the next year.
Net investment income includes gross income from property held for investment such as interest, annuities and royalties. It does not include capital gains and qualified dividends eligible for tax-favored treatment. The maximum tax rate for long-term capital gain and qualified dividends is only 15% as opposed to ordinary income taxed as high as 35%. However, you can elect to include long-term capital gain and qualified dividends as net investment income if you are willing to forfeit the preferential tax rate.
4. Business interest: The interest incurred in a trade or business, or in the production of rental or royalty income is fully deductible. That's pretty straightforward. Unlike the deductions for mortgage interest and investment interest, there are no limits on deductible amounts.
Of course, this is only a brief summary of the main rules. Obtain professional advice for your situation.

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