Interest Deduction Definition

What Is the Interest Deduction?

Interest deduction causes a reduction in taxable income. If a taxpayer or business pays interest, in certain cases the interest may be deducted from income subject to tax. Some examples of interest payments that can be deducted are:

Interest payments for a mortgage on a rental property can also be subtracted from the cost of operating the rental. Interest deductions are allowed primarily to encourage home ownership and investment activity.

Businesses also receive a deduction from their taxable revenues in the form of bond interest. If a business has issued bonds—which are essentially a loan to the business—the organization will have to pay interest on those loans. The interest paid to bondholders reduces the business’ revenue and therefore decreases the amount of taxable income the business will claim.

How the Interest Deduction Works

Interest deductions for individuals face some limitations. You must itemize your deductions on Schedule A to claim home mortgage interest or margin interest expenses. With higher standard deductions, fewer taxpayers are choosing to itemize. Generally, your deduction for margin loan interest is limited to net investment income. If you own a rental property, interest payments are among the expenses that may be deducted, along with other ordinary and necessary expenses. Rental expenses such as interest are deducted on Schedule E.

Interest deductions for businesses do not face the same choice between itemizing or taking a standard deduction. In the U.S., interest paid to bondholders is a deductible expense, along with other business expenses before taxable income, or profit, is determined. Essentially, the interest paid to bond investors is considered another type of business expense.

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