You can generally deduct all interest you pay or accrue during the
tax year on debts related to your trade or business. Interest relates
to your trade or business if you use the proceeds of the loan for a
trade or business expense. It does not matter what type of property
secures the loan. You can deduct interest on a debt only if you meet
all the following requirements.
- You are legally liable for that debt.
- Both you and the lender intend that the debt be
- You and the lender have a true debtor-creditor
If you are liable for part of a business debt, you can deduct only
your share of the total interest paid or accrued.
You and your brother borrow money. You are liable for 50% of the
note. You use your half of the loan in your business, and you make
one-half of the loan payments. You can deduct your half of the total
interest payments as a business deduction.
Generally, mortgage interest paid or accrued on real estate you own
legally or equitably is deductible. However, rather than deducting the
interest currently, you may have to add it to the cost basis of the
property as explained later under Capitalization of Interest.
If you paid $600 or more of mortgage interest (including certain
points) during the year on any one mortgage, you generally will
receive a Form
1098 or a similar statement. You
will receive the statement if you pay interest to a person (including
a financial institution or a cooperative housing corporation) in the
course of that person's trade or business. A governmental unit is a
person for purposes of furnishing the statement.
If you receive a refund of interest you overpaid in an earlier
year, this amount will be reported in box 3 of Form 1098. You cannot
deduct this amount. For information on how to report this refund, see
Refunds of interest later in this chapter.
Expenses paid to obtain a mortgage.
Certain expenses you pay to obtain a mortgage cannot be deducted as
interest. These expenses, which include mortgage commissions, abstract
fees, and recording fees, are capital expenses. If the property
mortgaged is business or income-producing property, you can amortize
the costs over the life of the mortgage.
If you pay off your mortgage early and pay the lender a penalty for
doing this, you can deduct the penalty as interest.
Interest on employment tax deficiency.
Interest charged on employment taxes assessed on your business is
Original issue discount (OID).
OID is a form of interest. A loan (mortgage or other debt)
generally has OID when its proceeds are less than its principal
amount. The OID is the difference between the stated redemption price
at maturity and the issue price of the loan.
A loan's stated redemption price at maturity is the sum
of all amounts (principal and interest) payable on it other than
qualified stated interest. Qualified stated interest is
stated interest that is unconditionally payable in cash or property
(other than another loan of the issuer) at least annually over the
term of the loan at a single fixed rate.
You generally deduct OID over the term of the loan. Figure the
amount to deduct each year using the constant-yield method,
unless the OID on the loan is de minimis.
De minimis OID.
The OID is de minimis if it is less than one-fourth of 1% (.0025)
of the stated redemption price of the loan at maturity multiplied by
the number of full years from the date of original issue to maturity
(the term of the loan).
If the OID is de minimis, you can choose one of the following ways
to figure the amount you can deduct each year.
- On a constant-yield basis over the term of the loan.
- On a straight-line basis over the term of the loan.
- In proportion to stated interest payments.
- In its entirety at maturity of the loan.
You make this choice by deducting the OID in a manner
consistent with the method chosen on your timely filed tax return for
the tax year in which the loan is issued.
On January 1, 2001, you took out a $100,000 discounted loan and
received $98,500 in proceeds. The loan will mature on January 1, 2011
(a 10-year term), and the $100,000 principal is payable on that date.
Interest of $10,000 is payable on January 1 of each year, beginning
January 1, 2002. The $1,500 OID on the loan is de minimis because it
is less than $2,500 ($100,000 × .0025 × 10). You choose to
deduct the OID on a straight-line basis over the term of the loan.
Beginning in 2001, you can deduct $150 each year for 10 years.
If the OID is not de minimis, you must use the constant-yield
method to figure how much you can deduct each year. You figure your
deduction for the first year using the following steps.
- Determine the issue price of the loan. Generally,
this equals the proceeds of the loan. If you paid points on the loan
(as discussed later), the issue price generally is the difference
between the proceeds and the points.
- Multiply the result in (1) by the yield to maturity.
- Subtract any qualified stated interest payments from the
result in (2). This is the OID you can deduct in the first
To figure your deduction in any subsequent year, follow the above
steps, except determine the adjusted issue price in step
(1). To get the adjusted issue price, add to the issue price any OID
previously deducted. Then follow steps (2) and (3) above.
The yield to maturity is generally shown in the
literature you receive from your lender. If you do not have this
information, consult your lender or tax advisor. In general, the yield
to maturity is the discount rate that, when used in computing the
present value of all principal and interest payments, produces an
amount equal to the principal amount of the loan.
The facts are the same as in the previous example, except that you
deduct the OID on a constant yield basis over the term of the loan.
The yield to maturity on your loan is 10.2467%, compounded annually.
For 2001, you can deduct $93 [($98,500 × .102467) -
$10,000]. For 2002, you can deduct $103 [($98,593 × .102467)
Loan or mortgage ends.
If your loan or mortgage ends, you may be able to deduct any
remaining OID in the tax year in which the loan or mortgage ends. A
loan or mortgage may end due to a refinancing, prepayment,
foreclosure, or similar event.
If you refinance with the original lender, you generally cannot
deduct the remaining OID in the year in which the refinancing occurs,
but you may be able to deduct it over the term of the new mortgage or
loan. See Interest paid with funds borrowed from original lender
under Interest You Cannot Deduct, later.
The term "points" is often used to describe some of the
charges paid by a borrower when the borrower takes out a loan or a
mortgage. These charges are also called loan origination fees, maximum
loan charges, or premium charges. If any of these charges (points) are
solely for the use of money, they are interest.
Because points are prepaid interest, you cannot deduct the full
amount in the year paid. (For an exception for points paid on your
home mortgage, see Publication 936.)
Instead, the points reduce the
issue price of the loan and result in original issue discount,
deductible as explained in the preceding discussion.
Partial payments on a nontax debt.
If you make partial payments on a debt (other than a debt owed the
IRS), the payments are applied, in general, first to interest and any
remainder to principal. You can deduct only the interest. This rule
does not apply when it can be inferred that the borrower and lender
understood that a different allocation of the payments would be made.
If you make an installment purchase of business property, the
contract between you and the seller generally provides for the payment
of interest. If no interest or a low rate of interest is charged under
the contract, a portion of the stated principal amount payable under
the contract may be recharacterized as interest (unstated interest).
The amount recharacterized as interest reduces your basis in the
property and increases your interest expense. For more information on
installment sales and unstated interest, see Publication 537.
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