In lower-interest-rate environments, interest tracing becomes increasingly relevant for individuals and businesses. Interest tracing is a tax principle used to determine the deductibility of interest expenses based on the use of borrowed funds. Below is a brief overview of how it works and its implications.
Interest expense can be either deductible or non-deductible for tax purposes. Deductible interest can be subtracted from your taxable income, often associated with business or investment expenses. Deductible interest includes mortgage interest on a primary or secondary home, student loan interest, business interest, and interest on loans used for investment purposes. These deductions can help reduce your taxable income. In contrast, non-deductible interest cannot be subtracted and typically pertains to personal expenses. For example, personal interest, such as personal credit card interest and interest on loans used to purchase tax-exempt securities, is generally not deductible. The specific rules and limits for deductible interest can vary based on the type of loan or investment and an individual’s financial situation.
Understanding Interest Tracing
Interest tracing rules require taxpayers to allocate interest expenses to specific uses of borrowed funds. This allocation determines whether the interest is deductible and, if so, in which category (e.g., business, investment, personal). Effective interest tracing becomes essential for optimizing financial decisions and minimizing costs as rates fluctuate.
Impact of Lower Interest Rates
When interest rates fall, borrowing costs decrease, making it more attractive to take out loans for various purposes. However, the deductibility of the interest depends on how the borrowed funds are used. Here are some key considerations:
- Refinancing Opportunities: Lower rates may prompt refinancing of existing loans. It's crucial to trace the use of the refinanced funds to ensure continued interest deductibility.Deductible interest generally includes mortgage interest on a primary or secondary home, student loan interest, and interest on loans used for investment purposes. When refinancing a mortgage, the interest remains deductible if the refinanced funds are used to buy, build, or substantially improve your home. However, the interest may not be deductible if the funds are used for personal expenses, such as paying off credit card debt.
- Investment Strategies: Investors might leverage low-interest loans to invest in higher-yielding assets. Proper interest tracing ensures that the interest expense is deductible against investment income. For tax purposes, investment interest expense refers to the interest paid on money borrowed to purchase taxable investments, such as stocks or investment properties. This interest is deductible up to the amount of your nonqualified net investment income, which includes ordinary dividends, interest income, and short-term capital gains, but excludes tax-advantaged income like municipal bond interest and qualified dividends and long-term capital gains. If your investment interest expense exceeds your net investment income for the year, the excess can be carried forward to future years. This allows you to potentially reduce your taxable income in subsequent years when you have sufficient investment income to offset the interest expense. On the other hand, currently, there is an annual election available to treat qualified investment income as ordinary income to deduct the interest. Properly tracing and documenting the use of borrowed funds is crucial to maximize these tax benefits and ensure compliance with IRS regulations.
- Business Expansion: Businesses can take advantage of cheaper borrowing costs to finance expansion. Accurate interest tracing helps maximize tax benefits by ensuring that interest expenses are correctly allocated to business activities. For tax purposes, business interest expenses are generally deductible, but there are limitations, under 163(j) of the Internal Revenue Code.
In summary, interest tracing is essential as interest rates come down. It allows borrowers and investors to adjust their strategies, reduce costs, and maximize returns. Understanding how to manage and allocate interest expenses or income effectively in such environments can significantly affect long-term tax outcomes.
If you have questions about how interest tracing rules apply to your borrowing strategy or want to better understand the tax deductibility of interest expenses, please contact Withum’s Founders and Tech Executive Services Team. Our team can help you make informed decisions and maximize available tax benefits in today’s rate environment.
Authors: An Ngo | [email protected] and Nicole Angiuoli, CPA | [email protected]
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