Interest is sometimes called the cost of money, since it is the amount paid by a borrower to a lender over time in addition to the principal of a loan. In some cases, the IRS allows taxpayers to deduct interest paid on a loan from their taxable income. Only an individual legally obligated for a debt can deduct interest expenses.
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Not all loans are eligible to have their interest expenses deducted for tax purposes, and the deciding factor is how the money is used. To bear deductible interest, a loan must be for investment purposes and not personal use. Interest paid on a loan to purchase a car for personal use, credit card debt, and loans for other personal expenses cannot be deducted. Interest paid on margin loans in investment accounts, loans used to buy securities, student loans and mortgages on qualified residences can be listed as itemised deductions.
Line 14 of Schedule A of Form 1040 is the most common method of itemising interest expense as a tax deductions. The step-by-step instructions on Form 4952 can assist taxpayers in determining how much interest they are eligible to deduct. Even interest paid on qualifying loans can only be deducted up to the amount of the investment's income.
A qualified residence for interest expense deduction purposes is either a main home or a second home. The main home is where an individual lives most of the time, and can be any kind of residence with sleeping, cooking and toilet facilities. A second home is any other owned residence. Unless the second home is rented out, it does not need to be used during the year for the interest payments to be deducted. If it is rented, the home must be used by the owner for 10 per cent of the number of days it is rented, and not less than 14 days.
Interest on student loans is usually not taxed, but is handled a bit differently than other loan interest. The interest on student loans is not itemised on Schedule A because it is treated as an adjustment to income. The adjustment is only available, however, to independent taxpayers with a modified income less than £45,500 (in 2008) and not married filing individually.
A taxpayer must allocate prepaid interest over the tax years to which it applies. This means the interest on any qualifying loan can be deducted, but only up to the amount that would have been due during that tax year according to the loans regular amortisation. Any interest paid over that amount can be claimed as a deduction in futures years to which they apply.
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