Avoiding Pitfalls of Interest Deduction Rules

Under current Internal Revenue Service (IRS) regulations, amounts that may be deducted for interest paid on non-mortgage loans will depend on how and when the borrowed funds are spent. The rules stipulate that interest deductions for investment or business loans may be lost when the loan proceeds are not spent for their intended purpose within 15 days and funds from the account are spent for other reasons. For example, assume a taxpayer takes out a $20,000 loan for investment purposes and places the money in an existing checking account. Ten days later, the individual writes a check for a $10,000 consumer purchase and 20 days later writes a check for the $20,000 investment. The IRS will assume that half the loan proceeds were used for the consumer purchase and half for the investment. Thus, 50% of the interest is classified as nondeductible consum­er interest.

Therefore, to obtain the best tax treatment, taxpayers must time their expenditures and document how pro­ceeds are spent. To maximize de­ductions, do the following:

1) Observe the 15-day rule.

2) Keep separate accounts for personal, business, and investment use.

3) Ensure that debts incurred for investments can be traced to the investment itself.

4) Consider home equity loans. Such loans are fully deductible as long as all mortgages on the home do not exceed the cost of the house plus improvements.

By observing the above you can successfully minimize your tax obligations and avoid costly errors.


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