Don’t Let Interest Cost You: What the IRS Is Watching and Why It’s Important

The way taxpayers structure loans and use borrowed funds can significantly impact their ability to deduct the interest on their loans. The tax rules do not focus on the type of loan, but on how the proceeds are actually used; a concept known as interest tracing. Properly applying these rules can create meaningful tax savings, while missteps may lead to lost deductions or costly penalties.

For individual income tax purposes, interest expense typically falls into four main categories:

1. Business Interest is the interest paid on money borrowed specifically for business purposes. Generally, this interest is fully deductible as a business expense on your tax return. However, under Internal Revenue Code Section 163(j), there are certain limitations on how much can be deducted for businesses whose average annual gross receipts over the previous three tax years exceed $31 million (for 2025). The deduction is capped at 30% of the business’s adjusted taxable income (ATI). Smaller businesses below this threshold are exempt from the limitation.
2. Investment Interest is any interest paid on money borrowed to purchase property held for investment such as stocks or bonds. This interest is deductible only up to the amount of your net investment income for the year. Net investment income typically includes interest, dividends, and certain capital gains and excludes qualified dividends and net long-term capital gains taxed at preferential rates. If your investment interest expense exceeds your net investment income, the excess can generally be carried forward indefinitely to offset investment income in future years. Note that any interest paid to produce tax-exempt income is not tax deductible. Making an election to tax capital gains and qualified dividends at ordinary income rates can be a smart tax planning move, particularly when investment interest expense is involved. Under IRS rules, this expense is only deductible up to the amount of net investment income, which typically excludes long-term capital gains and qualified dividends. However, by electing to treat these as ordinary income, taxpayers can increase their net investment income and unlock a larger deduction for otherwise limited investment interest. This strategy can lead to a lower overall tax bill, especially in years with substantial investment interest expense.
3. Mortgage Interest (Qualified Residence Interest) is interest paid on loans secured by your primary or secondary residence, the proceeds of which are typically used to buy, build, or substantially improve the home. Note that under federal law, interest on home equity loans or lines of credit (HELOCs) is deductible only if the loan proceeds are used to buy, build or improve the property securing the loan, and is included in the overall mortgage debt limit of $750,000 for loans taken after December 15, 2017, or $1 million for loans taken before that date. In contrast, California allows a deduction for interest on up to $100,000 of home equity debt regardless of how the funds are used, offering more flexibility at the state level. California also has a $1 million cap on mortgage debt regardless of when the loan was obtained.
4. Personal Interest is interest paid on loans used for personal expenses, which are costs that are not related to a trade or business, investments, or qualified home acquisition. Common examples of personal expenses include credit card charges for everyday purchases like groceries, dining, clothing, or vacations. It also includes interest on personal loans used for non-business purposes, auto loans for personal-use vehicles, and unsecured lines of credit used to pay for things like weddings, tuition, or household bills. Because these expenses do not produce taxable income or relate to an income-generating activity, the interest on loans used to pay for them is not deductible under current federal tax law. This has been the case since the Tax Reform Act of 1986, which eliminated the deduction for most personal interest.

Impact of the One Big Beautiful Bill Act (OBBBA)

The One Big Beautiful Bill, signed into law on July 4, 2025 makes permanent key mortgage interest provisions that were set to expire in 2025.

It permanently establishes the mortgage interest deduction limits at $750,000 for loans taken out on or after December 15, 2017, and $1,000,000 for loans taken out before that date. It also permanently classifies mortgage insurance premiums as deductible mortgage interest starting in 2026.

The bill does not change federal rules for deductions related to home equity loan interest, investment interest deductions, or the 30% business interest deduction under IRC Section 163 (j).

For business interest the OBBBA does restore the more favorable EBITDA-based calculation for Adjusted Taxable Income (ATI) starting in 2026, allowing businesses to deduct more interest under the 30% limitation of Section 163(j). The small business exemption still applies.

What Is Interest Tracing?

Interest tracing refers to IRS rules that determine the deductibility of interest based on loan usage. It’s not about the loan type or the lender; it’s about the destination of the funds. Debt proceeds must be traced to expenditures.

Real-Life Examples

• Example 1: Business Use – Fully Deductible

Jill is a freelance graphic designer who takes out a $30,000 personal loan. She spends $25,000 of that loan on new equipment for her business and uses the remaining $5,000 for a vacation.

Result: The interest on the $25,000 used for business equipment is deductible as a business expense on her tax return. This deduction is reported on a form called Schedule C, which is used by self-employed individuals to report their business income and expenses. However, the interest related to the $5,000 spent on the vacation is considered personal and is not deductible.

• Example 2: Home Equity Loan – Mixed Use

Rick and Julie take out a $100,000 home equity line of credit (HELOC). They use $50,000 to remodel their kitchen, $30,000 to buy stocks, and $20,000 to pay off credit card debt.

Result: The $50,000 used for home improvements may qualify for the mortgage interest deduction.

The $30,000 used for investments will qualify as investment interest and may be  deducted provided there is sufficient investment income.

The $20,000 used to pay personal debt is not deductible.

Even though it is a home equity loan, the deductibility depends entirely on how the funds were used and not on what secured the loan.

• Example 3: Rental Property – Proceeds Used Personally

Cotter refinances his rental property and pulls out $50,000 in equity. He uses $20,000 to renovate the rental and $30,000 to help pay for his daughter’s college tuition.

Result: The interest on the $20,000 used for the rental property is deductible as an expense related to that property. This deduction is reported on a tax form called Schedule E, which is used to report income and expenses from rental real estate. However, the interest on the $30,000 used for personal purposes is not deductible.

• Example 4: Credit Card – Mixed Use

Jennie uses her business credit card to pay for $3,000 in advertising and $2,000 for a personal vacation. She carries a balance and pays interest.

Result: Sixty percent of the interest is deductible as a business expense. The remaining forty percent is personal and not deductible.

Recordkeeping Tips

To make sure you’re applying the rules correctly, follow these best practices:

1. Track how all borrowed funds are used and not just where they came from.
2. Use separate accounts or loans for business, personal, and investment expenses whenever possible.
3. Label transactions clearly in your accounting system or spreadsheet.
4. Maintain good documentation, including receipts, statements, and any loan agreements.
5. Consult with a tax advisor before mixing use or transferring funds between accounts.

Proper tracking allows you to claim every allowable deduction and defend it if questioned.

Final Thoughts

Interest deductibility isn’t determined by whose name is on the loan or where the money originated. It all depends on how the funds were actually used. While the rules remain consistent, accurately tracing loan proceeds is essential to maximize your deductions and avoid errors. Through proper planning debt can be structured to maximize interest expense deductions.

If you’re planning to borrow funds or want to ensure you’re maximizing deductions on existing debt, please contact us. We can help you navigate the rules, properly trace interest, and structure loan transactions to support your tax planning goals.

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