There are a couple misconceptions about debt that we answer questions about frequently. The first is that paying down debt is deductible. The second is that gain on the sale of an asset is the difference between the sales price and the amount owed on the asset. This post will address these two misconceptions.
Paying Down Debt is Deductible
Paying down debt is not deductible—debt is tax free when you borrow it, and it is not deductible when you pay it down. The tax deduction occurs when you spend the debt proceeds on deductible items.
Example: Zoogle, Inc. borrows $100,000 from a bank. It spends $50,000 on operating expenses such as payroll, advertising, and supplies; and $50,000 for equipment.
Zoogle does not recognize taxable income when it borrows the $100,000 because it has to pay the money back. Zoogle deducts $50,000 when it pays the operating expenses, and depreciates the other $50,000 paid for equipment over a number of years. While Zoogle can deduct interest payments on the debt, it cannot deduct principal payments. Doing so would lead to a double deduction—first when the debt proceeds are used to pay for expenses, and second when principal payments are made.
Debt Reduces Taxable Gain When an Asset is Sold
It is a common misconception that gain on the sale of an asset is the difference between the sales price and the amount owed on the asset.
For example, Terry owns a rental property she bought in 1990 for $140,000 with $30,000 cash and a $110,000 mortgage. In 2004, the property was worth $200,000 and Terry borrowed $60,000 against the home.
It is now 2013 and Terry sells the property for $180,000. After years of principal payments, Terry’ debt balance on the property is $170,000.
Terry believes her taxable gain is the difference between the sales price of $180,000 and what is owed on the property–$170,000, which is a $10,000 gain. However, her actual gain is the difference between the sales price and her original cost of $140,000 for a gain of $40,000.
In this example, Terry believes her gain is only $10,000 because this is the amount of cash she receives after the debt is paid down with sales proceeds. By borrowing against the property in excess of its original cost, Terry effectively received prepayments of the sales prices when she borrowed against the property. She pays tax on this prepayment when she sells the property.
If the debt balance could be used to reduce gain, someone could simply cash out tax-free by borrowing against the asset to its full market value, and then sell the property for no taxable gain.