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What Is an Interest Deduction?

By Theresa Miles
Updated May 17, 2024
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An interest deduction is an expense that a government tax authority allows a taxpayer to subtract from income before the government assesses an income tax. Not all types of interest payments are deductible. The government decides what type of interest can be deducted based upon public policy, which varies from country to country, worldwide. A country's tax code details whether the government allows any sort of interest deduction and lists the types of interest payments that qualify.

Many countries around the world tax the income made by individuals and businesses. This income tax is ordinarily based on a system of fundamental financial fairness that only assesses a tax on the income that is left over after the taxpayer pays all of his living and certain other expenses. The government decides what types of expenses are important enough to be deducted from income and publishes these decisions in a tax code. Every year, taxpayers declare the total amount of money made, known as gross income, and subtract from that total all of the expenses that the government allows. Taxpayers pay income taxes on net income, or the amount of money made after allowable expenses are deducted.

When a person borrows money, he often must pay interest on the amount. Interest compensates the lender for the use of the money. To the borrower, interest is an amount that must be paid in addition to paying back the principal amount of the loan and represents the cost of borrowing the money. In certain types of transactions, tax authorities can chose to treat interest as the type of expense that should be deducted from gross income.

The types of interest payments that governments choose to allow taxpayers to deduct often align with important public policy issues. In the US, for example, the government allows individual taxpayers to take an interest deduction for interest paid on home mortgages. This supports a public policy to encourage homeownership. Another common type of interest deduction in the US is for interest paid on student loans. This benefit is designed to support a public policy that favors the pursuit of higher education.

Businesses are taxpayers in most countries and can also take an interest deduction, as allowed under the business tax code. Many tax authorities treat interest that a company pays as a regular cost of doing business. This sort of treatment means that a business can deduct most of the interest it pays from its income, while individuals can only deduct certain types of interest. For example, a business that pays interest on a business credit card can deduct it from income as a business expense. Conversely, an individual who pays interest on a personal credit card cannot ordinarily deduct it from personal income, because consumer credit is not one of the expenses that tax authorities tend to feel is necessary.

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