Tax laws provide limited opportunities to deduct loan interest. Individuals typically can only deduct interest on student loans, a qualified mortgage and loans for the purchase of an investment. Those who are self-employed can also deduct interest on business loans. When a person takes the interest deduction depends on whether they file their taxes on an accrual or cash basis. Most individuals file as cash basis taxpayers and cannot deduct interest as it accrues.
The accrual basis of accounting is typically used by businesses to track the financial results of their operations, although some individuals might use it as well. Rather than reporting transactions when cash changes hands, someone using the accrual basis reports transactions when a determinable amount of cash will change hands. For example, say you sit down with your accountant to figure out your taxes at the end of the month. His fees for the meeting total $300, which you’ll pay when you get the bill. On the accrual basis, you would record the $300 expense when you met with the accountant, not when you pay the bill.
When Interest Accrues
Interest accrues on the principal of a loan while it’s still outstanding. Student loan companies often send reminders to students that their accrued interest is about to be capitalized, or rolled into the principal balance. Unless the student is an accrual basis taxpayer – most individuals use the cash basis for its simplicity – the interest expense can’t be deducted if it goes unpaid. Same goes for any other deductible interest. If you aren’t an accrual basis taxpayer, you’ll get the deduction when you actually fork out the cash.
Mortgage interest and investment purchase interest expenses are deductible on Schedule A for taxpayers who itemize their deductions. You can deduct your entire interest charge from purchasing a home – up to $1 million of acquisition debt – and even the interest from the first $100,000 of any home equity loan you take out. Unlike mortgage interest, investment interest is limited to net investment income and, with any other miscellaneous deductions, must exceed 2 percent of adjusted gross income to be deductible. Taxpayers can write off up to $2,500 of student loan interest while calculating adjusted gross income, which allows those who don’t itemize to still take the deduction. Similarly, an individual who’s self-employed can deduct business loan interest as a business expense on his Schedule C.
Changing Accounting Methods
When you file your first return, you select an accounting method. The Internal Revenue Service expects you’ll keep your future returns consistent with that method. If you want to change it, you will have to request approval to do so with the IRS. File Form 3115 to request the switch from cash basis to accrual basis, or vice versa. Switching between accounting methods could hide income and allow deductions to be taken twice, so Form 3115 asks for information to prevent unscrupulous filers from exploiting the differences in accounting methods.
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