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 repaid.
• You and the lender have a true debtor-creditor relationship.

Partial liability. If you are liable for part of a business debt, you can deduct only your share of the total interest paid or accrued.

Example. 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.

Mortgage. 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.

Statement. 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.

Prepayment penalty. 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 deductible.

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.

Example. 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.

Constant-yield method. 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.

1. 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.
2. Multiply the result in (1) by the yield to maturity.
3. Subtract any qualified stated interest payments from the result in (2). This is the OID you can deduct in the first year.

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.

Example. 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) - $10,000].

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.

Points. 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.

Installment purchase. 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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