Is Interest Paid to the IRS Deductible?
Deducting interest paid to the IRS is not always possible, but the source of the income that led to the tax bill determines your eligibility.
When facing a tax bill from the Internal Revenue Service (IRS), the addition of interest to the original amount can be a source of frustration. A common question that arises is whether this interest can be deducted on a tax return. The general answer is that interest paid on an underpayment of federal personal income tax is not deductible. This rule applies to the interest charged on the tax liability reported on individual tax returns, such as Form 1040.
The General Rule for Personal Tax Interest
The Internal Revenue Code classifies interest paid on underpaid personal taxes as “personal interest.” For individual taxpayers, this category of interest is explicitly non-deductible. This means if you owe additional tax after filing your Form 1040, whether due to a miscalculation or an audit, the interest the IRS charges on that deficiency cannot be claimed as a deduction to lower your taxable income in a future year.
This non-deductible treatment extends to interest paid on any underpayment of individual federal taxes, including income taxes, self-employment taxes, and alternative minimum tax. The logic behind this rule is that the underlying tax liability itself is a personal obligation, not an expense incurred in a business or investment context. Therefore, the interest associated with a failure to pay that obligation on time is also considered personal.
It is also necessary to distinguish interest from penalties. The IRS may assess various penalties, such as those for failure to file on time, failure to pay on time, or accuracy-related penalties for substantially understating your tax liability. These penalties are never deductible under any circumstances. The tax code views these as punishments for non-compliance, and allowing a deduction would undermine their purpose.
Exceptions for Business and Investment Activities
While the general rule prohibits deducting interest on personal tax underpayments, exceptions exist when the tax deficiency originates from specific types of income-producing activities. The deductibility of the IRS interest is determined by the nature of the underlying income that generated the tax. If the tax is attributable to a trade or business, the interest paid to the IRS on the underpayment is deductible as a business expense.
For a sole proprietor who files a Schedule C, “Profit or Loss from Business,” any tax deficiency related to that business income would generate deductible interest. This interest is claimed as an ordinary and necessary business expense directly on Schedule C. Similarly, a farmer who files a Schedule F, “Profit or Loss from Farming,” can deduct IRS interest on underpayments related to their farm income on that form.
Interest on tax owed from passive activities, such as rental real estate, can also be deductible. The interest expense is allocated to the rental activity and deducted on Schedule E, “Supplemental Income and Loss.” This reduces the net rental income or increases the net rental loss reported from the property.
For tax deficiencies related to investment activities, this interest is classified as investment interest expense. Its deductibility is limited to the amount of the taxpayer’s net investment income for the year. Taxpayers must use Form 4952, “Investment Interest Expense Deduction,” to calculate the allowable deduction, which is then reported as an itemized deduction on Schedule A. Any investment interest expense that exceeds the net investment income limit can be carried forward to future tax years.
Deductibility of State and Local Tax Interest
The rules for deducting interest paid to state or local tax agencies differ from those for the IRS. Interest paid on an underpayment of a state or local income tax is deductible on a taxpayer’s federal return. This is because the underlying state and local income taxes themselves are potentially deductible.
This interest is not treated as an interest expense but rather as a state and local tax payment. It is combined with other state and local taxes paid during the year, such as property taxes and either income or sales taxes. This total amount is reported as an itemized deduction on Schedule A of Form 1040.
A limitation applies to this deduction. Taxpayers are limited to a maximum deduction of $10,000 per household, per year ($5,000 if married filing separately) for all state and local taxes combined. This means that even if your combined state tax payments, including interest on underpayments, exceed this threshold, your federal deduction is capped at $10,000. This limitation is scheduled to expire after 2025 unless extended by new legislation.