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Maximize Your Tax Return: Understanding the Loan Interest Advantage

Loan interest can offer tax benefits—but only in certain cases. This blog from First National Bank and Trust breaks down which types of loan interest may be deductible, when it makes sense to itemize, and why keeping records matters. With tax laws set to change after 2025, now’s the time to plan ahead.

two hundred dollar bills on top of a check from the United States Government

The arrival of April reminds many of tax season, but smart financial management, including tax planning, isn't confined to a single month. It's a continuous process that should adapt to significant life events and changes in your financial situation. As we explored in our previous blog article (February 2024), How to Save Money on Your Taxes This Year, proactive planning is essential. A 20-year-old starting their career will have vastly different tax planning needs than a 60-year-old approaching retirement. However, the common thread is the importance of proactive planning. Thinking about what you can do this year to optimize your tax situation for next year is crucial at any stage of life.
 
At First National Bank and Trust, we're dedicated to helping our customers navigate these complexities. This post will focus on how loan interest can impact your taxes, offering valuable insights. Remember this information is for knowledge and should not replace professional tax advice. We highly recommend consulting with a tax advisor for personalized guidance.

How Loan Interest Can Impact Your Taxes

Loan interest is the cost you pay to borrow money. The amount of interest you pay depends on factors like the interest rate, the loan's term (how long you have to repay it), and the principal (the original amount you borrowed). In some cases, this interest can be tax-deductible, meaning you can subtract a portion of what you paid from your taxable income, potentially reducing your tax burden. However, whether or not you benefit from deducting loan interest depends on whether you choose to itemize deductions or take the standard deduction.

Itemizing vs. Standard Deduction: Which is Right for You?

When filing your taxes, you generally have two options for reducing your taxable income: itemizing deductions or taking the standard deduction. The standard deduction is a fixed dollar amount set by the IRS based on your filing status (single, married filing jointly, etc.). It simplifies the tax filing process for many people. Itemizing, on the other hand, involves listing out specific eligible expenses you incurred throughout the year.
 
You would choose to itemize if the total of your itemized deductions is greater than the standard deduction for your filing status. By itemizing, you can potentially lower your taxable income by a larger amount than if you took the standard deduction. Common itemized deductions include:
  • Home mortgage interest
  • State and local taxes
  • Charitable contributions
  • Medical expenses (above a certain percentage of your adjusted gross income)
  • Business expenses
 
Loan interest, such as mortgage interest, is one of the items that can be included in your itemized deductions. Therefore, it's only relevant to consider the loan interest deduction if you plan to itemize. If your total itemized deductions are less than the standard deduction, it's generally more beneficial to take the standard deduction.

Types of Loans and Their Tax Implications

There are several types of loans, each with different tax implications. Here are some of the most common types of loans:

Home Mortgages

For many homeowners, mortgage interest is one of the most significant tax deductions. If you itemize, you may be able to deduct the interest paid on your primary and sometimes a second home up to certain limits. This includes interest on loans used to buy, build, or substantially improve your home. Consult with a tax professional to understand the specific rules and limitations that apply to you.

Home Equity Loans

Home Equity loans allow you to borrow against the equity you've built in your home. If you use the proceeds from a home equity loan to buy, build, or substantially improve your home, the interest you pay on the loan may be tax-deductible when itemizing deductions, similar to a traditional mortgage. However, if you use the loan for other purposes, such as debt consolidation, vacations, or other personal expenses, the interest is generally not tax-deductible. It's crucial to keep detailed records of how the funds are used to substantiate any deductions. Consult a tax professional for specific guidance on your situation.

Student Loans

The interest paid on qualified student loans may be deductible, even if you don't itemize deductions. This is an "above-the-line" deduction, meaning you can take it even if you take the standard deduction. However, there are income limitations for this deduction, so it's essential to check the IRS guidelines or speak with a tax advisor.

Business Loan

If you're a business owner and have taken out loans for business purposes, the interest paid is generally deductible as a business expense on Schedule C of Form 1040 (Profit or Loss From Business). This can significantly impact your business's overall tax liability. First National Bank and Trust offers a variety of business loan options. Contact our business banking team to learn more.

Investment Loans

If you borrow money to purchase investments, the interest paid may be deductible as investment interest expense. However, this deduction is often limited to your net investment income. This deduction is taken when itemizing deductions.

Loan Fees and Closing Costs: What's Deductible?

Whether loan fees and closing costs are tax-deductible depends on the specific type of fee and the purpose of the loan.

Generally Not Deductible

Many common closing costs are not directly deductible in the year you pay them. These include:
  • Appraisal fees – Costs for assessing the value of the property.  
  • Title insurance – Protects the lender and/or buyer against title defects.  
  • Loan origination fees (unless considered points) – Fees charged by the lender for processing the loan.
  • Recording fees – Fees for recording the mortgage with local authorities.
These costs are generally added to the basis of your property. The basis is essentially your cost for the property, and it's used to calculate any gain or loss when you eventually sell the property. By adding these costs to your basis, you effectively reduce your potential capital gains (profit) when you sell.  

Potentially Deductible

There are a few exceptions where certain loan fees or closing costs may be deductible:
  • Points – Prepaid interest you pay to the lender at closing to reduce your interest rate. If these points meet certain IRS requirements, they can be deductible as mortgage interest. Points paid for the purchase of your main home are generally deductible in the year you pay them. Points paid for refinancing are generally deducted over the life of the loan.  
  • Real estate taxes – Property taxes paid at closing are generally deductible.  
  • Mortgage interest – As discussed earlier, mortgage interest is deductible when itemizing.  

Key Considerations

Purpose of the loan

The purpose of the loan significantly impacts deductibility. For example, if you refinance your mortgage and use the funds to improve your home, some of the closing costs associated with the refinance might be deductible. However, if you use the funds for personal expenses, they generally won't be.

Record keeping

Keeping detailed records of all closing costs and loan fees is crucial. Your closing disclosure document will provide a breakdown of these costs.

What to Think About and Next Steps

It's important to be aware that many of the tax rules discussed in this post, particularly those concerning mortgage interest and home equity loan interest deductions, were impacted by the Tax Cuts and Jobs Act (TCJA) of 2017. These changes, which included limitations on mortgage interest deductibility and significant restrictions on home equity loan interest deductions, are currently set to expire at the end of 2025. This means that unless Congress takes action to extend or modify these provisions, the tax rules will revert to what they were before the TCJA.
 
As we approach this potential shift in tax law, it's crucial to stay informed about any legislative updates and how they might affect your tax planning strategies going forward.
  • Record Keeping is Key: Maintain accurate records of all loan interest payments. This documentation is crucial when filing your taxes, especially if you plan to itemize.
  • Consult a Tax Professional: This blog post provides general information. For personalized advice tailored to your specific financial situation, it's essential to consult with a qualified tax advisor or accountant. They can help you determine whether itemizing is beneficial for you, maximize potential loan interest deductions, and ensure you're complying with all tax regulations.
 
If you have questions about your existing loans with FNBT or are considering new financing options, our experienced team is always here for you. Please apply online or visit us in-branch at one of our many Southern Wisconsin and Northern Illinois locations. Talk with a lender about your home renovation plans and budget and assess the financing options available.