Can I deduct interest I haven't paid?

August 26, 2008

From:  Richard
Date:  Sat, 18 Aug 2007

Sir,

I have a negative amortization loan for my principal residence. The lender only reports the interest paid on Form 1098.

When I looked at the rules for deducting interest, I didn’t see that it was required to be paid to claim a tax deduction.

Since the lender is advancing the funds to "pay" the interest and add it to my mortgage balance, I think it should be deductible.

What do you say?

Thanks much,
Richard

Answer

Date:  Wed, 22 Aug 2007

Hello Richard,

In order to claim a deduction for the unpaid interest, you would be required to adopt the accrual method of accounting.

Under the accrual method of accounting, income is reported when it is earned, whether it has been paid or not. Expenses are also deductible when they are incurred, subject to limitations based on "economic performance" and "all events" – more involved than I want to get here. The accrual method is mostly used by businesses – especially when they have inventories.

Under the cash method of accounting, income is mostly taxable when the payment is received and expenses are mostly deductible when they are paid.

Almost all individuals use the cash method of accounting. This makes tax reporting easier, because you can then "match" information on your income tax returns with the amounts on the information returns that you receive, including Form W-2, Form 1099 and Form 1098. Although you might have a lower tax from adopting the accrual method, you would probably be creating an accounting nightmare for yourself.

On the cash method of accounting, when you "borrow" from the same lender the amount to "pay" interest, it isn’t considered to be paid. (By the way, this also applies to margin accounts and equity lines of credit!)

In short, stick with deducting the amount based on Form 1098 from the lender, subject to the other limitations that apply to home mortgage interest.

Good luck!
Mike Gray

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