Taxes and Loan Interest…What’s Deductible?
IJ Zemelman Feb-25-2015
The IRS allows certain types of interest to be deducted from one’s US expat tax return. In order to file your US taxes appropriately, it’s important to know what types of interest you’re able to deduct and the types of interest for which tax deductions are not available. We will take a look at the various types of interest that can and cannot be used as deductions on your US income tax return.
Let’s review the types of interest for which you are able to claim deductions and that against which you cannot claim deductions on your US expat tax return.
Interest for Your Home Mortgage
Home mortgage interest is deductible, but there are certain rules by which you must abide. You may deduct interest on mortgage debt of up to $1M. Mortgage debt is defined as debt used to purchase or improve your primary home. You may only deduct mortgage interest on your primary residence and one other house. Mortgages on more than two homes are considered personal tax expenses and are nondeductible.
Interest for Your Home Equity Loans
The IRS allows deductions for the interest on your home equity loans. You are allowed to deduct interest for loans valued up to $100K on your US expat tax return. This is true for all home equity loans – no matter what you spend the money on. The limit of $100K is in addition to the $1M mentioned above on mortgage loans. That means that you can actually have up to $1.1M in mortgage and home equity loans and still claim all the interest against those debts.
It’s important to understand the difference between regular tax deductions and AMT (alternative minimum tax) deductions. While you are able to claim your home equity loan interest despite the item(s) on which you spend the money from the home equity loan on your regular US expat tax deductions, you are not allowed to claim interest for the AMT unless it was spent on constructing or improving your primary or secondary residence. You may not deduct interest via AMT if you spent the money, for example on a new car, college tuition, or any other expense not related to your first or second home.
Vacation Home Interest
For many expats, a vacation home is actually their second home. In this case, the mortgage interest on your vacation home is deductible. Tax deductions get a bit more complicated if you rent out your vacation home, to you are advised to speak with a qualified US expat tax professional if you earn rental income on your vacation home.
Interest on Investments
When you get a loan and use the money to purchase taxable assets for investment, the interest that results is referred to as an investment interest expense. The most common investment interest expense is on margin accounts through a brokerage firm. You may only deduct your investment interest which is equal to your taxable investment income. This applies to various royalties, short-term capital gains, qualified dividends, and some other types of investment interest. If you have more interest than you have investment income, you may carry the interest over to the following tax year. If in the following tax year, you still have more interest than you have investment income, you will be able to carry it over again.
You also have the option of treating part or all of your qualified dividends and long-term capital gains as investment income. The benefit of making this decision is that it allows you to deduct a higher amount of your interest accrued through your investment income. The negative result of this decision is that you will be taxed at a regular investment income rate which can be up to 39.6%. This is opposed to the normal rate of up to 20%.
In order to claim your investment interest, you must fill out Form 4952 to come up with your write-off amount. You may also utilize Form 4952 to report the amount of your qualified dividends and long-term capital gains that you want to treat as investment income.
You ARE NOT allowed to claim interest on loans which are used to purchase non-taxable investments such as muni-bond funds or municipal bonds. That being the case, if an aspect of your investment strategy is that you borrow money, the best decision to make from a tax perspective is to spend the proceeds of this debt to purchase investments which are taxable and buy the nontaxable investments with cash.
Interest on College Loans
If you fall into a qualifying tax bracket, you will be able to deduct up to $2,500 worth of interest associated with college loans. If you are in a high income bracket, you will not be eligible to claim this type of interest. If you want to be able to deduct interest off your college loan and you make too much to be eligible for such a deduction, consider taking out a home equity loan to pay for college tuition.
401(K) Loan Interest
Interest accrued on 401(K) loans is not deductible on your US expat tax return. This is generally not too big of a problem, because you are actually receiving the interest income. The most negative aspect of taking out a 401(K) loan is that you will be required to pay it back immediately if you become unemployed by the company for whatever reason. If you stay with the company through which you have a 401(K) plan, you will be taxed in the amount of the distribution you would have received which is equal to the amount of your loan balance. If this happens before the age of 59½, you will be assessed a tax penalty of 10% in addition to having been taxed as if you received a 401(K) distribution.
Interest on Credit Cards, Car Loans, and Other Types of Consumer Debt
You may only deduct interest on loans used to acquire a business related item. For example, if you are purchasing a vehicle to be used for business purposes, you will be able to deduct the interest on that loan. If you are using the loan to purchase a vehicle for personal use, you are not allowed to deduct the interest. You are also not allowed to deduct the interest accrued on credit card debt. The tax-wise decision in the case of purchasing a car or to pay off credit card debt is to take out a home equity loan and deduct the interest from that.
Unless you are borrowing to finance a business expenditure—like a car used in your sole-proprietorship business—you can generally forget about any tax breaks.
Interest Associate with Business Expenses
When you take out a loan to pay for business expenses, you are generally allowed to deduct the interest associated with that loan. Keep in mind that there are complicated rules imposed by the IRS which define your business expenditures, so make sure you speak with your US expat tax consultant before taking on this daunting task on your own.
I.J. Zemelman, EA is the founder of Taxes for Expats