Pub 535

You can generally deduct all interest you pay or accrue during the tax year on debts related to your trade or business. Interest relates to your trade or business if you use the proceeds of the loan for a trade or business expense. It does not matter what type of property secures the loan. You can deduct interest on a debt only if you meet all of the following requirements.

• You are legally liable for that debt,
• Both you and the lender intend that the debt be repaid, and
• You and the lender have a true debtor-creditor relationship.

Generally, the amount you can deduct is the amount agreed upon by both you and the lender as interest.

You cannot currently deduct interest that must be capitalized and (except for corporations) you can never deduct personal interest.

Mortgages. Generally, mortgage interest paid or accrued on real estate you own legally or equitably is deductible. However, rather than deducting the interest currently, you may have to add it to the cost basis of the property as explained later under Capitalizing Interest.

Statement. If you paid $600 or more of mortgage interest (including certain points) during the year on any one mortgage, you generally will receive a Form 1098 or a similar statement. You will receive the statement if you pay interest to a person (including a financial institution or a cooperative housing corporation) in the course of that person's trade or business. A governmental unit is a person for purposes of furnishing the statement.

If you receive a refund of interest you overpaid in an earlier year, this amount will be reported in box 3 of Form 1098. You cannot deduct this amount. For information on how to report this refund, see Refunds of interest later in this chapter.

Prepayment penalty. If you pay off your mortgage early and pay the lender a penalty for doing this, you can deduct the penalty as interest.

Points. The term "points" is often used to describe some of the charges paid by a borrower when the borrower takes out a loan or a mortgage. These charges are also called loan origination fees, maximum loan charges, or premium charges. If any of these charges (points) are solely for the use of money, they are interest.

These points are interest paid in advance and you cannot deduct them all in one tax year. Instead, you deduct part of the interest each tax year during the period of the loan, unless the interest must be capitalized.

To figure how much to deduct each year, divide the part of the loan period falling within your tax year by the total loan period. Then multiply this answer by the amount of prepaid interest. For example, if you are a calendar year taxpayer and take out a 10-year loan on October 1, 1997, three months of the loan period fall in your 1997 tax year. You can deduct 3/120 of the payment you made for the points on your 1997 tax return. You can deduct 12/120 of the prepaid interest on your 1998 tax return.

Any points you paid on a mortgage to acquire business property that have not been deducted over the life of the mortgage may be deducted in the year the mortgage ends. A mortgage may end due to a refinancing, prepayment, foreclosure, or similar event.

Expenses paid to obtain a mortgage. Certain expenses you pay to obtain a mortgage cannot be deducted as interest. These expenses, which include mortgage commissions, abstract fees, and recording fees, are capital expenses. If the property mortgaged is business or income-producing property, you can deduct the costs over the life of the mortgage.

Partial liability. If you are liable for part of a business debt, you can deduct only your share of the total interest paid or accrued.

Example. You and your brother borrow money. You are liable for 50% of the note. You use your half of the loan in your business, and you make one-half of the loan payments. You can deduct your half of the total interest payments as a business deduction.

Partial payments on a nontax debt. If you make partial payments on a debt (other than a debt owed IRS), the payments, in the absence of an agreement between you and the lender, are applied first to interest and any remainder to principal. You can deduct only the interest.

Installment purchases. If you make an installment purchase of business property, you will pay interest either as part of each payment or separately. If no interest or a low rate of interest is charged under the contract, you may have to determine the unstated interest amount. Generally, this may happen if the seller finances your purchase. Unstated interest reduces your basis in the property and increases your interest expense.