Anyone who has ever borrowed money knows that there are almost always costs involved. Whether it's a cash-advance fee from a credit card, closing costs for a mortgage, or underwriting expenses for companies tapping the credit markets through a bond offering, borrowers usually can't deduct the costs of debt financing immediately. Instead, they have to amortize those costs over the life of the loan. As you'll see below, the details can vary greatly by type of debt.
Business vs. personal debt
The most important distinction when it comes to debt financing costs is whether the loan is for business or personal reasons. Typically, most personal debt isn't eligible for a tax deduction anyway, so the question of amortizing isn't particularly relevant for tax purposes.
The big exception is mortgage debt for a personal residence, and there, special rules apply. Most closing costs follow the same amortization rules as other types of debt. Yet for points paid on a mortgage for a new home purchase or for money to improve your current home, an immediate deduction is available if certain tests are met. The home must be your primary residence, and it must be common to pay no more than the charged number of points on mortgages in your area. In addition, you have to pay the points from your own funds, rather than having the lender loan additional money covering them.
Apart from that exception, you'll typically have to amortize debt financing costs. That involves recognizing those costs over the lifetime of the loan using what's known as the effective interest method. This method is a bit more complicated than a straight-line method, but it results in faster recognition of deductions.
For instance, assume you take out a five-year loan and pay $5,000 in fees. A straight-line method would have you amortize $1,000 each year. However, the effective interest method requires that the amortized expense be a fixed percentage of the outstanding debt balance each year. Because early years have a larger outstanding debt balance, effective interest amortization results in deductions of more than $1,000 in early years, shrinking in later years below the $1,000 mark until the full $5,000 is recovered in the final year.
Being able to amortize debt-financing costs as quickly as possible results in getting faster tax benefits, which is generally a good thing. Exceptions that let you take those costs as current expenses are the best outcome for taxpayers, but amortizing is still better than having expenses disallowed entirely for tax purposes.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.