Tax Rules Differ by Category

News from RWHSG

Posted by Kim Chen on August 8th, 2015

The tax rules for interest deductions depend on which category the expenses are in. Here are the categories that apply to expenses that individuals can incur:

1. Business Interest is fully deductible. If you borrow money and immediately spend it to pay expenses incurred by your sole proprietorship or to purchase related supplies and equipment, you can deduct the interest as a business expense on your Schedule C, as long as you materially participate in the operation.

2. Passive Interest is a subcategory of business interest, but applies only to interest on loans to finance passive business activities in which you do not materially participate. The interest is treated as a passive expense item and is included in computing the overall taxable income or loss from the activity in question.

In general, if you have an overall taxable loss from the activity (after including the interest as an expense), you can deduct the loss only to the extent you have positive taxable income or gains from other passive activities.

If a passive activity generates overall positive taxable income, the interest expense simply offsets part of your profit from the activity.

3. Investment Interest deductions depend on how much income you have from investments. When interest expenses from investments exceeds investment income, the excess is carried forward to future years, over to the following tax year or the next year and so on until you have enough investment income to claim a write-off.

For most people, investment income consists of taxable interest income and short-term capital gains. You can also elect to treat all or part of your long-term capital gains and qualified dividends as investment income, in order to “free up” larger investment interest deductions.

However, gains and dividends treated as investment income are then taxed at your regular federal rate (which can be up to 39.6 percent in 2015) rather than at the preferential rate that would otherwise apply, which is no higher than 20 percent; and the 20 percent rate only affects singles with taxable income above $400,000, married joint-filing couples with income above $450,000, heads of households with income above $425,000, and married individuals who file separate returns with income above $225,000.

Capital gains on investments held less than a year are short-term capital gains and taxed at ordinary income tax rates of 10, 15, 25, 28, 33, 35 or 39.6 percent.

4. Personal Interest, also called consumer interest, is nondeductible unless it meets the definition of either:
•Qualified residence mortgage interest on your primary or second residence.
•Qualified education loan interest.