You can save yourself and your family money by knowing what the laws allow. Here's how to convert nondeductible interest into deductible interest.


Interest is the fee you pay for the use of someone else's money. But you can, in effect, lower that fee by writing it off as a deduction on your taxes. As with anything else involving taxes, there are rules and stipulations you must know.

To deduct interest on a debt, you must be legally liable for that debt. For example, assume you make a loan to your son, hoping he will repay you when he can. If no true debtor-creditor relationship is created, your son is not legally obligated to repay the loan and he will not be able to deduct any of the interest he pays you.

When you involve family members
Alternatively, if you co-sign a note for a loan made by a bank to your son, and if both of you are jointly liable on the note, you may deduct any interest you pay and he may deduct any interest he pays -- depending on what the money is borrowed for.

The key here is if you have a loan with a family member, make sure there is a note to back it up and make sure the terms of the note are kept. (If the money were to be used for personal reasons, the interest would still not be deductible. In that case, you might want to secure the debt with a home equity loan.)

What's deductible, what's not:
The following items are generally deductible as interest: mortgage interest or "points," if you are the buyer; mortgage prepayment penalties; and interest on a business loan and investment interest.

The following items are not deductible as interest: points, if you are the seller; service charges; bank credit card interest (unless used for a business or for investment purposes); interest from a personal loan; credit investigation fees; loan fees; interest relating to tax exempt income; and interest paid to a related taxpayer, unless there is an actual debtor-creditor relationship.

Some interest payments qualify as below-the-line deductions, which means the deductions are taken after you calculate your adjusted gross income. The type of deduction you may take depends on whether the money was borrowed for personal use, for rental or royalty property, or for your business.

All business interest, as well as rental and royalty interest payments, are allowed as above-the-line deductions. There are no limitations on such deductions, although rental interest may be restricted by the general limitation on "passive loss" deductions.

Interest of a personal nature, such as home mortgage interest, is a below-the-line deduction. So, too, is interest paid on a margin account with your broker.

The deduction for investment interest is limited to net investment income.

Personal interest you can deduct
Personal interest is no longer deductible except for what the tax people call "qualified residence interest."

There are other limits on the deductibility of residence interest. The maximum amount of mortgage debt on your residence is $1 million, or $500,000 in the case of a married individual filing a separate return. If you approach the limit, remember that the cost of your house includes more than the amount paid to the seller. It also includes appraisal fees, title search, title insurance, transfer taxes, broker's commissions paid by the buyer, survey fees, bank or lender fees, legal fees, mortgage taxes, and any other nondeductible closing costs such as postage. It could also include the purchase of additional land adjacent to your home.

Home equity loans: Seize the opportunity
Now that credit card loans and personal loans are no longer deductible, home equity loans have become increasingly popular. That is because these loans are deductible. Home equity indebtedness is any amount owed (other than mortgage debt) on a qualified residence. Interest on home equity debt is deductible to the extent the debt does not exceed $100,000 (or $50,000 for a married individual filing separately). The beauty of home equity interest is that how you use the money is irrelevant. Money can be borrowed for vacations, parties or to pay off other debt.

The deductibility of home equity interest provides substantial opportunity for sophisticated tax planning. The interest rate on home equity debt is usually calculated based on the current prime rate, plus one or two percentage points. If you own a home and owe several thousand dollars in credit card debt at rates of 18% to 21%, it would be a financial slam dunk to pay off that debt with a home equity loan. Not only would you pay a lower rate, but you could also write off the interest as a tax deduction.

Getting to the points
Another area of home ownership where people routinely miss potential tax savings involves the points they pay to borrow money. Banks often charge fees, or points, for the privilege of borrowing money. The term "points" is sometimes used to describe the charges paid by a borrower. They are also called loan origination fees, maximum loan charges or premium charges. If the payment of any of these charges is solely for the use of money, then it is considered interest.

A point is equal to 1% of the loan amount, so on a $100,000 mortgage each point costs you $1,000. If you pay off a mortgage over 30 years, each point on a 6% loan adds 0.22 percentage points to the interest rate. Thus, a 6% loan that includes four points has an effective interest rate of 6.88%.

Deductible points – if you do the right thing
The amount you pay in points is deductible in full in the year of payment only if the loan is to buy or improve your main home. Points paid to refinance your home mortgage are not deductible in the current year. They must be deducted on a pro-rated basis over the life of the loan. For example, assume $2,400 in points is paid on a 20-year refinancing loan. You would deduct $10 per month for each month of each year the loan remains due ($2,400 divided by 240 months). If you refinance again, or sell the property, all non-deducted points would be deductible in that year.

The term "points" is also used to describe loan placement fees that a seller might pay to a lender to arrange financing for the buyer. Buyers can now deduct seller-paid points on mortgages so long as the purchase price of the home is reduced by the amount of the seller's payment. This rule does not apply to improvement (rather than acquisition) loans, or loans not made for your principal residence.

Staying on top of the law
The key in all of these explanations is that you must make yourself aware of the laws. You can save yourself and your family money by knowing what the laws allow.

As a final note, for instance, you can cut your tax bill by paying legitimate interest to another family member in a lower tax bracket.

Assume you are in the 28% tax bracket in 2003 (down from 30% in 2002) and you borrow money from your 14-year-old daughter's custodial account and pay $1,500 in interest secured by your home (home equity interest). Regardless of what you do with the money, you have created a $420 tax savings ($1,500 x 0.28) because the loan can be deducted from your tax bill. Assuming she has no other income, your daughter will pay no tax on the first $700 of interest paid and, thanks to some nifty maneuvering by Congress in the fall of 2001, only 10% on the balance for a total tax bill of $80 ($800 x 0.10). By merely reshuffling the paper, you saved the family $370.

One last point: the tax code is evolving, thanks to the 2003 tax bill. Tax rates were chopped this summer. The 30% rate for 2002 becomes 28% in 2003, a level it wasn't supposed to hit until 2006  

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