Indebtedness expenses are the costs you incur when you borrow money, and under federal tax law the deductible piece is almost always interest, along with a handful of related charges: loan origination fees (points), original issue discount, bond premium, and sometimes commitment fees. Whether you can deduct any of it, and when, depends less on the loan itself than on what you did with the borrowed funds.
Section 163(a) of the Internal Revenue Code starts generously: interest paid or accrued on indebtedness during the tax year is allowed as a deduction.1Office of the Law Revision Counsel. 26 USC 163 – Interest The rest of Section 163 then carves that allowance into categories, exceptions, and limitations that take back a great deal of it.
What Counts as an Indebtedness Expense
The main component is interest. Several other financing charges travel with it:
- Loan origination fees, or points, which are upfront charges for arranging a loan and treated as prepaid interest.
- Original issue discount (OID), the built-in discount when a bond or note is issued below face value, representing interest that accrues over the life of the instrument.
- Bond premium, the excess paid above face value when debt is issued at a price higher than par, which reduces the effective interest cost over time.
- Commitment fees, charges for a lender’s promise to keep funds available, which may be treated as interest depending on the arrangement.
Each has its own timing rule. Points generally spread over the loan term. OID accrues annually. Bond premium offsets interest expense. Those timing rules are covered further down.
What You Did With the Money Decides the Deduction
The tax treatment of interest hinges on the use of the borrowed funds, not what secures the loan. This is the principle behind the Treasury’s interest tracing rules.2eCFR. 26 CFR 1.163-8 – Allocation of Interest Expense Among Expenditures A home equity loan used to buy inventory for your business generates business interest even though your house secures the debt. A personal loan used to buy stocks generates investment interest, not personal interest.
That means you need to track the actual use of every dollar borrowed. Commingling loan proceeds with personal funds in a single bank account makes tracing difficult and often leads to a less favorable classification. Parking borrowed funds in a separate account until you deploy them is the simplest way to preserve the category you want.
The Four Interest Categories
Once you trace where the money went, the interest falls into one of four buckets. Each has its own deduction rules, and misclassifying between them is one of the most common errors on both business and individual returns.
Business Interest
Interest on debt used in a trade or business is generally deductible, but most businesses face a cap under Section 163(j). Any interest over the cap carries forward indefinitely and gets another chance in a future year.3eCFR. 26 CFR 1.163(j)-2 – Deduction for Business Interest Expense Limited – Section: Disallowed Business Interest Expense Carryforward The 163(j) rules are detailed in their own section below.
Investment Interest
Interest on money borrowed to buy or carry property held for investment is deductible, but only up to your net investment income for the year. Net investment income means investment income (dividends, non-qualified interest, short-term capital gains, and royalties not from a business) minus investment expenses. Anything above that amount carries forward with no expiration.4Office of the Law Revision Counsel. 26 USC 163 – Interest – Section: Limitation on Investment Interest
One nuance to know: qualified dividends and long-term capital gains count as investment income for this calculation only if you elect to treat them that way. Making that election costs those gains their preferential rate, so they get taxed as ordinary income. The math depends on your bracket and the size of the disallowed interest.
Passive Activity Interest
Interest on debt used to fund a passive activity, typically a rental or a business in which you don’t materially participate, gets folded into that activity’s profit-or-loss calculation. If the activity shows a net loss, the passive activity loss rules under Section 469 generally block the deduction until you have passive income from another source or dispose of the activity entirely.5Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited The interest itself isn’t separately limited; it’s just one component of the overall passive loss.
Personal Interest
Interest that doesn’t fall into any of the three categories above is personal interest, and it’s not deductible. Credit card interest, auto loan interest on a personal vehicle, and interest on a loan used to pay personal expenses all land here.6Office of the Law Revision Counsel. 26 USC 163 – Interest – Section: Disallowance of Deduction for Personal Interest Two exceptions matter for most individuals.
Qualified residence interest. You can deduct interest on up to $750,000 of mortgage debt ($375,000 if married filing separately) used to buy, build, or substantially improve your main home or a second home, as long as the debt is secured by that residence.7Internal Revenue Service. Publication 936 (2025) – Home Mortgage Interest Deduction If you took out the mortgage before December 16, 2017, the older $1 million limit ($500,000 if filing separately) still applies to that loan. Interest on a home equity line of credit is deductible only if the proceeds go toward buying, building, or substantially improving the home that secures it. Using a HELOC to pay off credit cards or fund a vacation makes the interest nondeductible personal interest.8Internal Revenue Service. Real Estate (Taxes, Mortgage Interest, Points, Other Property Expenses) 2
Student loan interest. You can deduct up to $2,500 of interest paid on qualified education loans without itemizing. For 2026, the deduction begins phasing out at a modified adjusted gross income of $85,000 for single filers ($175,000 for joint filers) and disappears at $100,000 ($205,000 joint).9IRS. Rev. Proc. 2025-32 – Section: Interest on Education Loans
The Section 163(j) Cap on Business Interest
For businesses above a certain size, Section 163(j) is the single biggest constraint on deducting interest. Understanding the formula, the exemption, and the carryforward is essential for any business carrying significant debt.
The Formula
Your allowable business interest deduction for the year equals your business interest income, plus 30% of your adjusted taxable income (ATI), plus any floor plan financing interest (a narrow category mostly relevant to vehicle dealers).10eCFR. 26 CFR 1.163(j)-2 – Deduction for Business Interest Expense Limited Anything above that ceiling is disallowed for the current year.
ATI is the lever that matters most. For tax years beginning in 2026, the calculation uses an EBITDA-style approach: you start with taxable income and add back depreciation, amortization, and depletion. That is a meaningful change from 2022 through 2024, when those items could not be added back and the effective cap was tighter. Restoring the add-back permanently increases the amount of interest most capital-intensive businesses can deduct.
The Small Business Exemption
Section 163(j) doesn’t apply at all if your business qualifies as a small business taxpayer. For tax years beginning in 2026, you meet the test if your average annual gross receipts over the three preceding tax years are $32 million or less.11IRS. Rev. Proc. 2025-32 – Section: Limitation on Use of Cash Method of Accounting You must aggregate the gross receipts of all related entities, and tax shelters are ineligible regardless of size.12eCFR. 26 CFR 1.163(j)-2 – Deduction for Business Interest Expense Limited – Section: Small Business Exemption
Certain industries can also elect out. Real property trades or businesses and farming businesses may elect to be treated as excepted trades or businesses, but the trade-off is that they must use the slower alternative depreciation system for their real or farm property.
The Carryforward
Business interest disallowed in the current year carries forward indefinitely and is retested against the formula each year.3eCFR. 26 CFR 1.163(j)-2 – Deduction for Business Interest Expense Limited – Section: Disallowed Business Interest Expense Carryforward Partnerships work differently: disallowed interest is allocated to individual partners as excess business interest expense, and each partner can only deduct it when that same partnership generates enough income to absorb it.
Points, OID, and Bond Premium: When You Deduct Them
Not every cost of borrowing is straightforward annual interest. The fees and pricing adjustments around a debt issuance have their own timing.
Loan Origination Fees and Points
Points paid to secure a mortgage or other loan are a form of prepaid interest. The general rule is that you spread the deduction ratably over the life of the loan rather than deducting the full amount upfront.13Internal Revenue Service. Topic No. 504 – Home Mortgage Points On a 30-year mortgage, that means dividing the points by 360 monthly payments, then deducting based on the payments actually made that year.14Internal Revenue Service. Real Estate (Taxes, Mortgage Interest, Points, Other Property Expenses) 6
Points on a mortgage to purchase your principal residence are the big exception. You can deduct them in full in the year paid if you use the cash method and the points meet certain requirements (paid at closing, within the customary range for the area, and not substituted for other closing costs).13Internal Revenue Service. Topic No. 504 – Home Mortgage Points If you refinance and later pay off the loan early or refinance again with a different lender, any remaining unamortized points become deductible in that final year.14Internal Revenue Service. Real Estate (Taxes, Mortgage Interest, Points, Other Property Expenses) 6
Original Issue Discount
When a company issues a bond or note for less than face value, the difference between the issue price and the redemption price is OID. Economically it is interest: the borrower received less cash upfront but owes the full face amount at maturity. The issuer accrues and deducts OID over the life of the instrument even if no cash payment is made until maturity. The holder reports the same accrual as income.
Bond Premium
The reverse happens when debt is issued above face value. The excess is a bond premium, and it reduces the issuer’s effective interest cost. Rather than deducting the full stated interest each period, the issuer amortizes the premium as a reduction of interest expense over the bond’s life. The net deduction each year is smaller, reflecting the true economic cost.
When Interest Has to Be Capitalized Instead
Not all interest can be deducted currently even when it otherwise qualifies. Under Section 263A, interest incurred during the production of certain property must be capitalized into the asset’s cost rather than expensed. This applies to property with a long useful life, property with an estimated production period exceeding two years, or property costing more than $1 million with a production period exceeding one year.15Office of the Law Revision Counsel. 26 USC 263A – Capitalization and Inclusion in Inventory Costs A company building its own warehouse or constructing a ship adds the construction-period interest to the asset’s basis and recovers it over time through depreciation.
Forms You File
Two IRS forms handle most indebtedness expense reporting, and filing the wrong one (or skipping one you needed) invites questions.
Form 8990 is required for any taxpayer with business interest expense, a disallowed business interest carryforward, or current-year excess business interest expense. Partnerships allocating excess taxable income or excess business interest income to partners also file it. The main exception: if you qualify as a small business taxpayer (average gross receipts of $32 million or less for 2026) and have no excess business interest expense from a partnership, you don’t file.16IRS. Instructions for Form 8990 (Rev. December 2025) Businesses operating exclusively in excepted trades or businesses (real property, farming, regulated utilities, or employee services) are also exempt.
Form 4952 is for individuals deducting investment interest expense. You must file it unless all three of these are true: your investment income from interest and ordinary dividends exceeds your investment interest expense, you have no other deductible investment expenses, and you have no carryover of disallowed investment interest from the prior year.17IRS. Form 4952 – Investment Interest Expense Deduction
What It Costs to Get It Wrong
If an incorrect interest deduction leads to a substantial understatement of income tax, the IRS can impose an accuracy-related penalty of 20% of the underpayment.18Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments If the error involves a gross valuation misstatement, the penalty doubles to 40%. A substantial understatement generally means the tax you reported was off by the greater of 10% of the correct tax or $5,000 for individuals.
The most common mistakes are misapplying the tracing rules (claiming business interest on a loan whose proceeds went to personal use), ignoring the Section 163(j) cap, or failing to capitalize interest under Section 263A. Documenting how loan proceeds were spent and completing Form 8990 correctly are the best defenses.