Paying interest on borrowed funds is an expectation for individuals and businesses alike. Interest payments can add up, but they can also be deductible on your tax return, helping to reduce your tax liability. However, not all interest payments are deductible. There are four specific criteria that must be met in order to claim a tax deduction on interest payments.
Criteria for deductible interest payments
1. Payment due or payable in the year
In order to claim a tax deduction on interest payments, the interest must have been paid or payable in the year. For example, if you missed a payment at the end of the year but the interest was still due it would be considered interest payable. Similarly, if payments are made annually on June 30th, there is still six months of interest owing at year end and thus, this amount would be considered interest payable.
2. Legal obligation to pay interest
There must be a legal obligation to pay the interest in order for it to be deductible. This means that there should be an agreement in place, such as a loan agreement or mortgage contract, to support the requirement to pay interest.
3. Money borrowed is used to earn income
The money borrowed must have been used for the purpose of earning income in order for the interest payments to be deductible. There must be an expectation of making money on the borrowed funds, such as through an investment portfolio or a rental property. Funds borrowed for a personal loan, such as for a car or mortgage on your house, are not deductible. You’ll want to make sure there is a direct linkage between the funds borrowed and the income earned.
4. Amount must be reasonable
Lastly, the amount of interest must be reasonable for it to be deductible. If the interest amount is not reasonable, then your deduction will be limited to a reasonable level and a portion of the interest cost will not be deductible. This circumstance may arise if you are paying interest at a rate higher than market rates or paying interest to a related party.
Claiming a tax deduction on interest payment can be a helpful way to reduce your tax liability. However, its important to ensure that you meet the above criteria in order to qualify for the deduction. If you have questions about whether your interest payments are deductible, its best to speak with your Virtus Group tax professional to guide you through the process.