Taxes and Reducing Debt

taxes-and-reducing-debt

Find tax benefits from home ownership, student loan and investment interestWith so many people concerned about holding onto their jobs and keeping up with consumer debt payments, it’s no wonder that more and more people are concerned about reducing their debt to manageable levels. The key to trimming your debt is just like any other diet: Cut your spending as you would cut calories and exercise more—in this case, exercise your self-control. The similarity to a typical diet regimen doesn’t end there; the remedy is often easier to explain than to execute. But once you commit yourself to your goal, there are ways you can use the tax laws to slim down your debts.

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The interest you pay on consumer debt falls into two distinct categories: tax-deductible and nondeductible. Mortgage interest is generally tax-deductible. So is interest paid on student loans and money borrowed to buy investment property, including stocks, bonds, and mutual funds, up to certain limits. For tax years prior to 2018, certain amounts of home equity debt are deductible. However, beginning in 2018, the interest paid on this type of debt is no longer deductible unless it is used to buy, build, or substantially improve your home. There are also limits on the amount of debt that the interest is on that can qualify for a deduction.

Interest paid on credit cards and car loans is not deductible. In theory, using a home-equity loan to pay off high-interest credit card debt is a good idea for years in which there is no restriction on the ability to deduct interest on home equity debt (tax years prior to 2018). For example, trading $10,000 of 18% nondeductible credit card debt for $10,000 of 7.5% deductible debt would slice the after-tax carrying cost from $1,800 to $540 a year for a taxpayer in the 28% bracket.

In reality, this strategy works best if you commit yourself to paying down your home-equity debt and claim the tax-deductible interest on your tax return as quickly as possible, without allowing your zero-balance credit card statement to entice you to go on another shopping spree. Using your home as a piggy bank has its limits, and even tax-deductible interest costs money.

Homeowners rejoiceTax breaks for homeowners fall into three categories: when you buy, while you own, and when you sell. Taking advantage of those tax breaks, adjusting your tax withholding on your paychecks, or scaling back on your estimated quarterly tax payments if you are self-employed, will give you more money in your pocket each month to apply to your debts.

For most people, buying a home opens the door to a vast array of tax breaks in the form of itemized deductions. In 2021, individuals can claim a basic standard deduction of $12,550. For heads of households, the deduction is $18,800. For married couples filing a joint return, the standard deduction is $25,100.

Stack that up against a homeowner who might have $12,000 in mortgage interest plus $5,000 in local property taxes. In the 25% federal tax bracket, that combined $17,000 tax deduction saves you $4,250 a year. That’s more than $350 a month in tax savings that you can apply to pay off your debts.

And once you start itemizing your deductions, you may be able to lower your tax bill even further by writing off charitable contributions, state income taxes, and possibly medical bills. More tax savings means more money to pay down debts. In contrast, a single person in the 25% bracket claiming the standard deduction of $12,550 in 2021 would save $3,100 in taxes.

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While you own your home, you can borrow against your equity—which is the difference between what you owe and what your house is worth. You can choose either a loan for a fixed amount, often tied to a fixed interest rate, or a line of credit that you can use at will, usually with variable interest rates. However, the interest paid on home equity loans is subject to specific rules to determine if it is deductible.

When you sell your home, up to $250,000 of profit ($500,000 for married couples filing jointly) is tax-free. Downsizing to a less-expensive home, particularly for new retirees, can be a great way to free up cash and pay off debts. To qualify for the tax-free profit, you must own and live in the house for at least two of the five years before the sale.

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Student loan interestIt’s no secret that the cost of a college education is getting increasingly expensive. It is one of the biggest debts faced by recent college grads—or their families. The good news is you can deduct up to $2,500 in interest you pay on qualified education loans for college or vocational school expenses, whether or not you itemize your deductions, subject to income limits. This tax break is known as an “above the line deduction” that lowers the amount of your income subject to tax. The deduction is available for loans to pay for educational expenses for you, your spouse or dependents.

For 2021, the deduction is phased out when modified adjusted gross income is between $70,000 and $85,000 for individuals and $140,000 and $170,000 for married couples filing jointly.

Investment interestThere’s a corollary to the old adage that “you have to spend money to make money.” Sometimes “you have to borrow money to invest money.” And if you do, the interest you pay on that borrowed money, in most cases, is tax-deductible.

For the interest to be deductible, the investment has to be designed to produce taxable income. For example, interest on a margin loan from your broker to invest in stocks or taxable bonds qualifies. But if the borrowed money is used to invest in tax-exempt securities, the interest is not deductible. Ditto if you borrow to buy a single-premium life insurance policy or annuity. Congress doesn’t want the IRS subsidizing loans to help you purchase tax-favored investments.

But there’s a limit to how much investment interest you can deduct. The write-off is restricted to the amount of taxable investment income you report. Investment income is defined as interest, annuities, or royalties, but not net capital gains or qualified dividends. (The government doesn’t necessarily want you deducting investment interest in your regular tax bracket that may be as high as 37% in 2021 if your gains are taxed at a maximum of 20%.) However, any interest you’re unable to deduct because of the cap is not lost forever. It may be carried over to future years and deducted as soon as there is sufficient investment income to offset it, or on the final tax return after your death.

Remember, with TurboTax, we’ll ask you simple questions about your life and help you fill out all the right tax forms. With TurboTax, you can be confident your taxes are done right, from simple to complex tax returns, no matter what your situation.


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