Interest Expense

Interest is an amount you pay for the use of borrowed money. To deduct interest you paid on a debt you must be legally liable for the debt. There must be a true debtor-creditor relationship. Additionally, you generally must itemize your deductions, unless the interest is on rental or business property or on a student loan.

If you prepay interest, you must allocate the interest over the tax years to which it applies. You may deduct in each year only the interest that applies to that year. However, there is an exception that applies to points paid on a principal residence.

Types of interest you can deduct as itemized deductions on Form 1040, Schedule A include investment interest (limited to your net investment income) and qualified residence interest. You cannot deduct personal interest. Personal interest includes interest paid on a loan to purchase a car for personal use. Personal interest also includes credit card and installment interest incurred for personal expenses. Items you cannot deduct as interest include points (if you are a seller), service charges, credit investigation fees, and interest relating to tax-exempt income, such as interest to purchase or carry tax-exempt securities. For information on points, refer to Tax Topic 504. For information on investment interest see Publication 17, Your Federal Income Tax.

You can deduct student loan interest on Form 1040 or Form 1040-A. For information on deducting student loan interest, refer to Tax Topic 456.

Qualified residence interest is interest you pay on a loan secured by your main home or a second home. Your main home is where you live most of the time. It can be a house, cooperative apartment, condominium, mobile home, house trailer, or houseboat that has sleeping, cooking and toilet facilities.

A second home can include any other residence you own, and treat as a second home. You do not have to use the home during the year. However, if you rent it to others, you must also use it as a home during the year for more than the greater of 14 days or 10 percent of the number of days you rent it, for the interest to qualify as qualified residence interest.

Qualified residence interest and points are generally reported to you on Form 1098, Mortgage Interest Statement, by the financial institution to which you made the payments. The following mortgages yield qualified residence interest and you can deduct all of the interest on these mortgages:

• A mortgage you took out on or before October 13, 1987 (grandfathered debt)
• A mortgage taken out after October 13, 1987, to buy, build, or improve your home, (called home acquisition debt) up to a total of $1 million for this debt plus any grandfathered debt. The limit is $500,000 if you are married filing separately.
• A mortgage taken out after October 13, 1987, that does not qualify as home acquisition debt (called home equity debt), up to a total of $100,000 throughout 2010. The limit is $50,000 if you are married filing separately. Home equity debt is further limited to your home's fair market value minus grandfathered debt and home acquisition debt.

If one or more of your mortgages does not fit into any of these categories, refer to Publication 936, Home Mortgage Interest Deduction, to figure the amount of interest you can deduct.

You may be able to take a credit against your federal income tax if you were issued a mortgage credit certificate by a state or local government for low income housing. Use Form 8396, Mortgage Interest Credit, to figure the amount. For further information, please refer to Publication 530, Tax Information for Homeowners. For information on the First-time Homebuyers Credit, refer to Topic 612.

You may be subject to a limit (phase-out) on some of your itemized deductions including mortgage interest. For more information on the limitations based on the adjusted gross income please refer to the Instructions 1040 (General Inst.).