In the United States, costs associated with debt financing can be deducted -- or amortized -- over the course of the life of the debt. While this is generally true for both U.S. income tax purposes and under U.S. Generally Accepted Accounting Principles, there are some differences in the financial or tax reporting depending on whether the debt is personal or business related and for what purpose the debt is incurred.
Capitalization of Financing Costs
Borrowers often incur significant costs in the issuance or obtaining of debt financing. These costs may include legal fees, title search fees, and for larger corporations, even fees to investment banks and other advisors. These costs may generally not be expensed when incurred and are instead capitalized on an entity’s balance sheet as "deferred financing costs." The capitalized financing costs do not include interest expense that is to payable over the life of the financing. Interest costs are typically deducted as incurred during the life of the financing, although exceptions exist for anticipated interest costs that differ appreciably from market rates available at the time the financing is made.
Amortization of Financing Costs
The deferred financing costs capitalized on the balance sheet may be deducted over the finite remaining life of the debt financing. This deduction is known as amortization and is generally taken pro-rata over the term of the debt. As an example, if an entity incurs $100,000 of costs associated with financing a debt issuance for a 5-year bond, the entity may deduct $20,000 in the first year following the issuance date of the bond, and $20,000 every year thereafter.
Individuals and Pass-Through Entities
In the United States, individuals and certain business entities known as pass-through entities (typically entities reporting as partnerships for federal tax purposes) cannot always amortize and deduct debt financing costs as business expenses. Financing costs incurred in order to allow a partnership to make a distribution to its partners must be tracked as a debt-financed distribution. The deductibility of the distribution is then tied to the partner’s underlying use of the distributed funds. In addition, financing costs incurred in order to make certain investments (such as stocks, bonds or mutual funds) must be tracked as investment costs. The deductibility may be limited to the underlying investment gains of the owners.
In the United States, financing costs incurred by individuals in order to buy a personal residence are subject to the same capitalization and amortization rules as other deferred financing costs. A significant exception to this are points incurred to pay down the interest rate on the mortgage. Often, points are deductible in the year paid. However, it should be noted that the Internal Revenue Service has issued a series of stringent rulings on the deduction of points, broadly aimed at limiting the deduction of excess points by a borrower when the points paid exceed those commonly incurred by home buyers in the region.