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Getting a Handle on Interest Deductions

Tax code complexities are all too common, but one area that few sole proprietors have a handle on is interest expense. To help, A.J. Cataldo, Ph.D., CPA, of Northeastern University in Boston, breaks down the five classifications (or categories) of interest expense and explains their level of deductibility:
 
Business interest from a trade or business:
This is fully deductible without limitation (see taxpayer Form 1040, Schedule C); however, the taxpayer must be “at risk” for the amounts financed.

Passive activity interest, such as rental property:
The IRS places limits on rental losses exceeding $25,000, where excess amounts are available for carry-forward to future years and are subject to combination with other passive activity expenses and/or comparison against passive activity losses (see taxpayer Form 1040, Schedule E).

Qualified residence interest: This is limited for high-income taxpayers in homes valued at more than $1.1 million, but available only to taxpayers able to itemize their personal deductions (see taxpayer Form 1040, Schedule A).

Investment interest: This is subject to net investment income limitations and/or available for carry-forward, and available only to taxpayers able to itemize their personal deductions (see taxpayer Form 4952 and Form 1040, Schedule A).

Personal interest: This is not deductible, except after 1997 for certain student loan interest (see taxpayer Form 1040, p. 1).