You might view the IRS somewhat warily, but perhaps your attitude would mellow a little if you thought of them as a friend who helped you out with some of your loan payments. In effect, the deductibility of certain types of loan interest means that the taxman does help to make those loans more affordable.

Of course, this friend has gotten a little less generous over the years. There was a time when even interest on car loans and credit card debt was deductible, but those days are long gone. However, deductions on certain other types of loans are alive and well.

Types of deductions and their limitations

Here are some common loan types that have tax-deductible interest, along with a discussion of the limitations on the tax benefits:

1. Primary residence mortgage interest. Your primary residence is the home you live in most of the time. Interest on a loan used to acquire or improve this residence can be tax deductible, as long as that loan is secured by the property. This applies to loans of up to $1 million ($500,000 if you are married but file separate tax returns), as long as the amount of the loan does not exceed the cost of your home plus any improvements.
2. Second home mortgage interest. Interest on a loan used to acquire or improve a second home may be tax deductible, subject to the same limitations described above, though the dollar limit applies to the total amount of loans you have on your first and second homes. Also, if you rent out your second home for part of the year, you will only qualify for a tax deduction on a loan used to acquire it if you live in that second home for the greater of 14 days or 10 percent of the total days for which it is rented out.
3. Home equity loan interest. Interest on a home equity loan secured by a first or second home and used to improve a qualified property can be tax deductible, subject to the combined dollar limits described above. In addition, a home equity loan which exceeds the applicable dollar limit or which is used for purposes other than to improve the property can qualify for deductibility of interest up to a total of $100,000 ($50,000 if married and filing separately). In order to qualify for tax deductibility, the acquisition debt and home equity debt on a property cannot exceed its fair market value.
4. Student loan interest. Interest on student loan debt can be deductible up to a total of $2,500 in any one tax year. The primary limitation is that your modified adjusted gross income cannot exceed $75,000 if you are single, or $155,000 if married and filing jointly.

As with any deductions, the ability to benefit from deducting loan interest depends on your filing a return on which you itemize rather than take the standard deduction, and upon your having sufficient income to be offset by the amount of the deductions.

Applying this knowledge when shopping for a loan

It’s good to be aware of these deductions when it’s time to file your taxes, but it is even better if you are familiar with them when you are considering a loan, so you can factor the tax implications into your decision-making. Here are some examples:

1. Size of down payment. A larger down payment will result in your paying less interest cost over the life of the loan, but when weighing that cost against other considerations, be sure to reduce that cost by the benefit of the tax deduction.
2. Refinancing. When weighing interest differentials against the costs of refinancing, be sure to base your decision on the after-tax interest amounts of your current and proposed loan.
3. Budgeting. When figuring out how a loan fits into your budget, be sure to analyze it after reducing the interest by any applicable tax deduction.

The U.S. tax code is notoriously complex and subject to change from year to year. So, before you count on the deductibility of any interest, you should check with your tax adviser to see if a deduction would apply to your situation and the type of loan involved. The guidelines above should help point you toward the types of loans for which a deduction might apply.