Interest tax deductions

Tax consequences are only one of several factors you should consider when evaluating debt, not even necessarily the most important.

Subject to a number of restrictions.

Correct. It's only the interest on money you borrowed to *buy* the stock that might be deductible as investment interest expense.

No.

There is a general concept of proceeds tracing. To survive a tax audit, you should be able to show that loan proceeds for which you want to deduct interest were not mingled with other funds used for non-deductible personal expenses. This involves having separate bank accounts, making close-in-time transactions, and so on, similar to the rules for tracing separate property in states where marriages are subject to community property rules.

If you do an internet search for the title "I.R.S. SETS TIGHT RULE ON INTEREST" you should find a free 1987 New York Times article which provides more information.

-Mark Bole

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Tax deductions only function to lower the effective interest rate. They make a certain type of debt "better" but not necessarily to the point of being called "good debt".

That's true, but if a vehicle is the only plausible way to get to the job that provides significant income and the only method of obtaining a vehicle is through an auto loan, then I would contend it is a "good debt". In theory, the loan yields more than it costs.

That's true also, but would you consider a current mortgage charging

Same question as the mortgage hypothetical above

... The moral of the story is that certain debts do get a tax deduction which makes employing them more advantageous. However, the terms of the debt will play a much larger factor in determining whether it is "good" or "bad" debt.

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I see that there are income restrictions and restrictions as to the amount of the mortgage.

One should then avoid purchasing a vehicle directly from a brokerage account that has a loan against the stock, but i am not sure how to free up the cash without selling stock.

-- Ron

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Schedule A limitations based on income, yes. Also, only first and second home qualify. Also, you have to keep track of acquisition vs. equity debt, the law is designed to prevent endlessly refinancing your equity and still fully deducting all interest.

That's the whole point of the law: personal interest to buy a car is not deductible. Interest on money borrowed *directly* for investment purposes is.

As previously mentioned, tax consequences are just one of many factors in determining whether borrowing money makes sense.

-Mark Bole

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Good debt vs bad debt- there appears to be a gray area in interpreting good and bad (what is the definition of good?).

My understanding is that mortgage debt is not good because it is tax deductable, it is good because the asset the debt was used to secure goes UP in value over the life of the loan. Car debt is not bad debt because it is not tax deductable, car debt is bad because the value of the product the loan was used to secure has decreased in value at the end of the loan term.

The fact the mortgage interest is tax deductable is icing on the cake relative to the appreciation of the house itself, which is the real profit from the good debt.

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I agree that the tax deductibility doesn't define good or bad. As you said, it's "icing on the cake". "Good" and "bad" are surely relative terms, but I don't agree that the ending value of the asset relative to the loan expense defines good or bad either. I consider it to be merely a consideration also.

Back to the car example... suppose I live in an area with no access to alternative transportation (buses, taxis, subways, commuters, etc...). Furthermore, suppose I could work from home and earn $50k a year, or take a job working from an office 15 miles away and earn $100k a year. So by purchasing a modest vehicle, under reasonable terms, I relinquish some money to the interest gods, but in the end make significantly more. If I were in that position I would feel my investment (the car) was a smart one. Do you disagree? I can imagine this scenario to be quite common among recent college grads.

Now if I managed to find a car that APPRECIATED in value that would just make the investment that much better ("icing on the cake").

In the end, I think the determinants for "good debt" and "bad debt" are highly case specific. But in general (and as I said earlier), if the loan yields more than it costs, it's a "good debt".

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I see that the deduction doesn't disappear entirely based on income. There is a maximum of a 60% reduction and a maximum reduction of 3% of income beyond $157,000(?).

Since interest is fungible, it's a silly rule. But, my broker says to use such loans as temporary ways to manage investments.

I was just looking at the situation where one can borrow for less than what investments return. In which case, tax deductions are important.

-- Ron

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It may be silly, but it's the law, and the interest-tracing rules apply.

For example: (a) You have $30,000 in a checking account. You buy $30,000 in stock, send in $15,000 in partial payment, and use the other $15,000 to buy a car. You end up with $0 in checking, $30,000 in stock, a $15,000 margin loan, and a car. The interest is deductible.

(b) You have $30,000 in a checking account. You buy $30,000 in stock, send in full payment of $30,000. Then you tell the broker to send you $15,000 (you don't sell anything) and use it to buy a car. You end up with $0 in checking, $30,000 in stock, a $15,000 margin loan, and a car. The interest is NOT deductible.

(I posited this scenario in misc.taxes.moderated several years ago, and the consensus was as described above -- even though the outcomes are identical, the interest-tracing rules and the sequencing of events makes the first scenario deductible but the second scenario non-deductible).

-- Rich Carreiro snipped-for-privacy@rlcarr.com

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Ron Peterson wrote: [...]

You really should consider that there are two sets of "rules" -- economic, and tax. From an economic view, you're right - interest is interest, a dollar is a dollar, and so on.

For tax purposes, actually the rule is pretty straightforward: generally, interest is NOT deductible (wasn't always the case). Then, there are three major exceptions: student loan interest, most mortgage interest on personal residence(s), and any interest that can be DIRECTLY traced to the production of taxable income, such as a business, rental, or capital investment. If the tracking of proceeds rule was not followed, there would be no way to enforce the general rule and yet still allow exceptions.

I don't understand this.

What I think you're trying to ask is, why can't you defer income tax on the gains from your investments while still enjoying the use of those gains by taking cash loans against them and deducting the interest?

That's double-dipping (or, single-dipping from an empty container). It's the same reason why there's a cap on how much equity debt qualifies for home mortgage interest deduction. For both a home and stock investments, you have two basic choices:

1. cash out, pay the tax (if applicable -- homes and stocks both have built-in breaks on taxes), and use the money for whatever you want, interest-free.
2. borrow, continue to defer the tax on the gains, but don't expect a deduction for the interest.

-Mark Bole

I agree and I would extend this to a more generalized rate of return argument. If I can earn a higher rate that the rate of the loan, the loan is not bad regardless of purpose (well, almost regardless). For example, I could have paid cash for my last car, but at 0.9% interest I thought it made more sense to leave money in the market. That's the same reason I didn't put more down on my house.

-Will

william dot trice at ngc dot com

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On my last mortgage, I also only paid just enough to avoid PMI for the same reason.

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