Interest Tracing: How to Classify Your Interest Expense

The Internal Revenue Service (IRS) requires taxpayers to classify interest expenses to determine if they are deductible. This process, known as interest tracing, links the interest paid on a loan to the specific use of the borrowed funds. The purpose of the expenditure dictates the tax treatment of the interest, not the asset used as collateral for the debt. For example, interest on a loan secured by business equipment but used for a personal vacation is not a business expense. The tracing rules, found in Treasury Regulation 1.163-8T, provide the framework for allocating debt and its interest to the correct expenditure category.

Categories of Interest Expense

Trade or Business Interest

Interest paid on debt used to finance a trade or business is fully deductible. This includes loans for purchasing inventory, equipment, or for working capital, with the deduction taken on the appropriate business tax schedule. The Tax Cuts and Jobs Act of 2017 (TCJA) introduced a limitation for some businesses, capping the deduction at the sum of business interest income plus 30% of the business’s adjusted taxable income.

Investment Interest

When you borrow money to purchase property held for investment, like stocks or bonds, the interest paid is investment interest. The deduction for this interest is limited to your net investment income for the year, which includes items like interest, non-qualified dividends, and short-term capital gains. If your investment interest expense exceeds your net investment income, the excess can be carried forward to be deducted against future investment income.

Passive Activity Interest

Interest on a loan used to fund a passive activity is subject to passive activity loss limitation rules. A passive activity is a trade or business in which the taxpayer does not materially participate, such as a rental property or a business where you are a silent partner. You can only deduct passive activity interest up to the amount of your income from all passive activities. Any net passive loss, including this interest, can be carried forward to offset passive income in future years.

Qualified Residence Interest

This category applies to interest paid on a mortgage to buy, build, or substantially improve a qualified residence, which includes your primary home and one other home. For tax years 2018 through 2025, interest is deductible on up to $750,000 of this acquisition debt. Interest on home equity loans is only deductible if the proceeds are used to buy, build, or substantially improve the home securing the loan. For this category, the collateral is a determining factor.

Personal Interest

Personal interest is not deductible. This category captures interest on any debt that does not fall into the other classifications. Common examples include interest on car loans for personal use, credit card debt for living expenses, and loans for vacations.

Applying the Tracing Rule

The allocation of interest follows the allocation of the debt. If you borrow funds and use them for a single purpose, the rule is straightforward. For instance, if you take a $50,000 loan and use the entire sum to purchase computers for your business, the debt is allocated to a trade or business expenditure, and all interest is business interest.

This direct tracing applies regardless of the collateral used to secure the loan. The same logic applies when loan proceeds are not disbursed directly to you. If you finance a business vehicle and the lender pays the car dealership directly, the debt is allocated to the business vehicle, and the interest is business interest. Once debt is allocated to an expenditure, that allocation remains until the debt is repaid or reallocated.

Tracing Funds from a Commingled Account

When loan proceeds are deposited into an account with other money, the IRS provides specific ordering rules. The default rule is that any expenditure from the account is treated as coming from the borrowed funds first, until the total loan amount is spent.

An optional 30-day rule allows you to treat any expenditure made within 30 days before or after the debt proceeds are deposited as being made from those proceeds. For example, if you bought $10,000 of stock on June 5th and deposited a $10,000 loan into that account on June 20th, you can treat the stock purchase as funded by the loan. This would make the associated interest investment interest.

If you deposit proceeds from multiple loans into one account, a first-in, first-out (FIFO) method applies. Expenditures are treated as coming from the loan deposited earliest. A detailed ledger of deposits and withdrawals is needed to apply these rules correctly.

Special Considerations for Debt and Repayments

Debt Refinancing

When you refinance a loan, the new debt is allocated in the same way as the debt being repaid. For example, if you refinance a $100,000 loan that was used to purchase investment securities, the new loan is also allocated to the investment purchase. Its interest retains the investment character. If the new loan is larger than the old one, the use of the excess funds must be traced separately.

Allocation of Debt Repayments

When a single loan is allocated to multiple types of expenditures, repayments are applied to the underlying debt in a specific order. This means you must fully pay off one category before payments are applied to the next. The order of repayment is:

• Personal expenditures
• Investment expenditures
• Passive activity expenditures
• Trade or business expenditures

Application to Pass-Through Entities

Interest tracing rules also apply to pass-through entities like partnerships and S corporations. When the entity borrows money, it traces the use of the proceeds to its expenditures, such as for business operations or investment property. The interest expense retains its character when passed through to partners or shareholders on their Schedule K-1. The owner then treats the interest on their personal tax return according to its original classification, subject to any individual limitations.