Why You Can’t Deduct Interest on Money You Didn’t Actually Borrow

With the introduction of the new auto loan interest deduction (up to $10,000), taxpayers are eager to see how much of their car loan interest can be deducted for 2026. But there’s a key rule that many people get wrong — and it becomes especially important when a trade-in is involved.

If you traded in a vehicle when buying your new one, your deduction only applies to the interest on the net financed amount, not the total interest listed on the loan if part of that financing represents value covered by your trade-in.

The Core Rule:

Only interest on the actual borrowed amount is deductible

If you traded in a car worth $8,000 and financed a new vehicle for $30,000, you didn’t really “borrow” the entire $30,000.

Instead:

• $8,000 came from your old vehicle
• $22,000 came from new financing

Your interest deduction is only based on the interest tied to that $22,000 portion.

Example Breakdown: Real-World Scenario

Purchase price of new car:

$30,000

Trade-in value:

$8,000

New amount financed:

$22,000

Loan interest paid for the year:

$1,920 total interest charged by lender

But if the lender reported interest as if the loan is based on $30,000, the IRS will expect you to deduct only interest attributable to the $22,000 portion actually borrowed.

Calculation:

Proportion borrowed = 22,000 ÷ 30,000 = 73.3%

Deduction allowed = 73.3% of $1,920 = $1,407.36

That is the deductible portion — not the full $1,920.

Why the IRS Enforces This Rule

A trade-in is treated as:

• partial payment from the taxpayer
• not borrowed money
• not interest-bearing
• not deductible

The deduction is designed to provide tax relief for interest paid on financed purchases, not on equity value that you rolled in from your trade-in.

Warning: This Is Where Many Taxpayers Get Flagged

Common incorrect filing behaviors:

• deducting full interest without accounting for trade-in
• ignoring trade-in value
• using lender-reported interest totals without adjustment
• deducting interest as if 100% of loan were financed with borrowed funds

These situations may trigger:

• TC 570 — Refund Hold
• TC 971 — Notice Issued
• potential document request
• request for proof of financing

In higher-risk cases:

• TC 420 — Audit Indicator

What Documents You Should Keep

For safe IRS compliance, retain:

• original purchase agreement
• trade-in credit statement
• finance contract
• amortization schedule from lender
• proof of VIN and vehicle details
• NHTSA VIN decode if claiming U.S.-assembly-based deduction
• interest-paid record (often Form 1098-like lender statement)

If questioned, you must show:

• how much was financed
• how much interest was tied to the financed portion

If You Have No Trade-In, This Is Simple

If you paid:

• cash down
• no trade-in

Then:

100% of the loan interest is deductible
(up to the $10,000 cap)

That’s the clean scenario the IRS prefers.

But If You Have a Trade-In, You Must Calculate Correctly

Use these steps:

1. Take vehicle purchase price
2. Subtract trade-in value
3. Result = actual amount financed
4. Deduct interest only attributable to that amount

This keeps you compliant.

When a trade-in is involved:

• part of your car’s cost was paid using old-vehicle value
• part was borrowed
• only the borrowed portion accrues deductible interest

Claiming interest on money you never borrowed is one of the fastest ways to get flagged.

Calculate correctly — and you’ll benefit from the deduction while staying fully compliant with IRS documentation standards.