Interest Deductions Top List of Tax Trouble Spots

QUESTION: Would it be possible for you to prepare a list of some of the tax changes we all should remember to think about when we start to work on our tax returns? I always start the process of collecting receipts in November, and I’m afraid I’m going to forget what’s what this year.--R. N.

ANSWER: Interest deductions will probably top the list of potential trouble spots for millions of taxpayers come filing time. Until this year, borrowed money was borrowed money for purposes of deducting interest expenses. It was all tax-deductible. No more. Now, every borrower who hopes to write off interest expenses must first determine if the interest expense is mortgage interest, business interest, personal interest, investment interest or so-called passive activity interest.

Keep in mind that if your only interest expense is the mortgage on your home, nothing has changed. Those costs remain fully deductible. Mortgage interest on a second principal residence, such as a beach cottage or a ski chalet, also is fully deductible.

But if you have borrowed money to finance the purchase of more than two houses, or if you have interest expenses from credit card charges, a car loan, school loan or any other type of consumer interest, filing time may well be more complicated than in the past.

Consider this example from tax specialists at the Price Waterhouse public accounting firm. You have borrowed money to buy three houses: Your principal residence, plus a vacation home in the desert and a ski chalet. You can only deduct the interest from two and you choose the main residence and the desert home. What do you do about the ski chalet when tax time rolls around?

If you use the chalet strictly for personal purposes, the interest expenses likewise are classified as personal interest costs and you can only deduct 65% of them this year. In future years, that type of interest is 40% deductible in 1988, 20% deductible in 1989, 10% deductible in 1990 and not deductible at all after 1990. (Interest on car loans, school loans and all other types of consumer interest also fall into this category.)

If you and your family never use the chalet, don’t participate in the management and retain a rental agent to rent it out, the interest expense is instead classified as passive interest. This new category of interest permits a deduction by taxpayers only to the extent that they have so-called passive income. No passive income, no deduction for passive interest.

On the positive side, however, you may carry interest from passive activities forward indefinitely--meaning that if you don’t have the income to offset it all now, you don’t automatically lose the deduction. You simply wait until a year when you do have sufficient passive income.

The ski chalet owner who refinances the mortgage on the chalet has still more questions to answer. If he uses the proceeds to buy a car, the interest is counted as personal interest and no longer deductible after 1990, as we have already seen. If the proceeds are put into the stock market, the interest is classified as investment interest. As is the case with passive interest, investment interest is a deductible expense only to the extent that the taxpayer has investment income.

Your records had better be good.

If you have children, you may be in for still more headaches come tax time. For starters, don’t forget that 1987 tax returns require Social Security numbers for all children over age 4. That alone can be a time-consuming process, so don’t wait until the last minute.

Second, if you have children under age 14 with unearned income over $1,000, that income will be taxed at your presumably higher tax rate beginning this year. In the past, it was taxed at the child’s lower tax rate. The so-called kiddie tax form that children with investment income will have to file isn’t simple, either, so allow extra time.

Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Los Angeles Times, 780 Third Ave., Suite 3801, New York, N.Y. 10017.