How to Get Interest Expense for a Tax Deduction

Interest expense is the financial cost incurred when borrowing money, a fundamental component of various personal and business financial arrangements. Understanding this expense is important for effective financial management, as it directly impacts an individual’s or organization’s financial position.

Understanding Interest Expense

Interest expense is the amount charged by a lender for the use of borrowed money. Lenders impose interest to compensate for the time value of money, the risk of default, and the opportunity cost of lending funds. This cost reflects that money available today is generally worth more than the same amount in the future.

Common sources of interest expense for individuals include mortgages, car loans, credit card balances, and student loans. For businesses, interest expense arises from bank loans, lines of credit, equipment financing, and bonds. Each financial instrument carries a specific interest rate that determines the cost of borrowing.

Calculating and Tracking Interest Expense

The calculation of interest expense involves applying an interest rate to the outstanding principal balance of a loan. Simple interest is calculated only on the original principal amount, while compound interest is calculated on the principal amount and also on the accumulated interest from previous periods. Most loans, such as mortgages and business loans, use compound interest, meaning the interest itself can begin to earn interest over time.

Amortization schedules detail how loan payments are allocated between principal and interest over the life of a loan. These schedules show that early payments on many loans consist largely of interest, with a smaller portion applied to the principal balance. As the loan matures, a greater percentage of each payment goes towards reducing the principal. Regularly reviewing these schedules or loan statements helps borrowers understand their interest.

Tracking interest payments is important for financial planning and tax considerations. Information regarding interest paid is found on monthly loan statements, credit card statements, and annual tax forms provided by lenders. Maintaining organized records of these documents ensures that all incurred interest can be accurately accounted for.

Recording Interest Expense in Your Books

Recording interest expense involves documenting the outflow of funds associated with borrowing costs. For businesses, interest expense is recognized on the income statement as a non-operating expense, reducing net income. This accounting practice ensures that the true cost of financing is reflected in the business’s profitability.

Individuals track interest payments using personal finance software, spreadsheets, or simple ledgers to monitor their cash outflows. While not formal accounting entries, these methods serve a similar purpose by providing a clear record of how much interest has been paid. Accurate record-keeping is important for both personal budgeting and tax preparation.

Maintaining records of interest payments, including dates, amounts, and the source of the debt, is important for financial management. These records support financial analysis, allowing individuals and businesses to assess their debt burden and plan for future payments. Such documentation also provides the necessary evidence for tax preparation purposes, ensuring compliance and supporting any deductions claimed.

Claiming Interest Expense for Tax Purposes

Not all interest paid is deductible for tax purposes; specific rules and limitations apply depending on the type of loan and its use. Understanding these distinctions is important for accurately claiming deductions on a tax return. The Internal Revenue Service (IRS) provides guidance on what interest expenses qualify.

Home Mortgage Interest

Interest paid on a qualified home mortgage can be a deduction for many individuals. A qualified home includes a main home and a second home. The deduction applies to interest on the first $750,000 of mortgage debt ($375,000 if married filing separately) for loans incurred after December 15, 2017. For mortgages taken out before this date, higher limits of $1 million ($500,000 if married filing separately) may apply.

This deduction is claimed by itemizing deductions on Schedule A (Form 1040). Homeowners receive Form 1098, Mortgage Interest Statement, from their lender by late January or early February, which reports the total interest paid during the year if it amounts to $600 or more. Interest on home equity loans or lines of credit is deductible only if the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan.

Student Loan Interest

Individuals who pay interest on a qualified student loan may be able to deduct a portion of that interest. A qualified student loan is one taken out solely to pay for qualified higher education expenses for the taxpayer, their spouse, or a dependent. The maximum deduction allowed is $2,500 or the amount of interest actually paid, whichever is less.

This deduction is an adjustment to income, meaning it can be claimed even if the taxpayer does not itemize deductions. The amount of the deduction is subject to phase-out rules based on the taxpayer’s modified adjusted gross income (MAGI), which can reduce or eliminate the deduction for higher-income individuals. Lenders report student loan interest paid on Form 1098-E if the amount is $600 or more.

Investment Interest Expense

Interest paid on money borrowed to purchase or carry property held for investment can be deductible. This includes interest on margin loans used to buy stock or loans for investment property. The amount of deductible investment interest is limited to the taxpayer’s net investment income for the year.

Net investment income includes interest, dividends, annuities, and royalties, but excludes long-term capital gains and tax-exempt interest. Any investment interest expense that exceeds the net investment income limit can be carried forward indefinitely to future tax years. This deduction requires itemizing on Schedule A (Form 1040) and may involve filing Form 4952, Investment Interest Expense Deduction.

Business Interest Expense

Businesses can deduct interest expense paid or accrued during the tax year. However, Internal Revenue Code Section 163 imposes limitations on this deduction for certain businesses. The deductible business interest expense is limited to the sum of the taxpayer’s business interest income, 30% of the taxpayer’s adjusted taxable income (ATI), and any floor plan financing interest expense.

This limitation affects larger businesses; many small businesses are exempt if their average annual gross receipts for the three prior tax years do not exceed a certain threshold, which was $30 million for 2024. Any business interest expense disallowed due to this limitation can be carried forward to succeeding tax years. Accurate record-keeping is important for substantiating all claimed interest deductions.