The Treasury Department, as part of its sweeping tax reform package, would make major changes in the way interest payments and income are treated for income tax purposes.

Treasury's basic purpose is to try to insulate taxes as much as possible from the effects of inflation. To that end, the department would adjust both interest payments and interest income for inflation. The only transaction fully exempt from the new treatment would be interest paid on a mortgage secured by a taxpayer's principal residence.

Most taxpayers could also effectively deduct up to an additional $5,000 without regard to a new series of limits on deductions Treasury would impose.

Essentially, Treasury wants to exclude from tax the portion of interest received by a lender that compensates him not for the use of his money, but for the fact that, because of inflation, when he is repaid the principal will be worth less than when he lent it.

A similar logic works on the side of the borrower, who gets to repay the loan in dollars worth less than when he took out the loan. In a sense, he has received a gain without actually realizing any taxable income.

On neither side is it possible to record precisely the actual gains and losses involved in such transactions. Treasury instead has proposed an adjustment -- called a fractional exclusion -- to approximate the gain and loss. (See table on Page E2.)

Simply put, Treasury would require a taxpayer to adjust his interest income by excluding from taxable income a certain fraction that would vary with the rate of inflation. Treasury, in constructing its table, assumed 6 percentage points of the interest rate represent a real return for loaning the money and the remainder the offset for inflation. A similar adjustment would be made for interest paid.

While some taxpayers would lose some of their deduction, the reduction in taxable interest income ought generally to mean lower interest rates than otherwise would be the case, Treasury argues.

There are some important exceptions in applying the proposed new rule and Treasury is still working on many of the details, particularly those involving netting interest and other investment income against interest payments.

The biggest exception, and the one likely to be the most important to most taxpayers, is mortgage interest paid on a principal residence. It would remain fully deductible so long as the size of the mortgage does not exceed the full market value of the property. In addition, because of other proposed limitations on interest deductions, Treasury warns that attempts to disguise borrowing for other purposes as home mortgage interest may be circumscribed by additional new rules.

After one's home mortgage interest is deducted, a series of steps are required to see how much additional interest may be deducted. The first is to determine the amount of net interest paid, if any. To do that, the taxpayer must subtract from interest paid all interest received.

Suppose a taxpayer had paid $1,000 in interest on a car loan and on credit card charges, and had also received $150 in interest on a savings account. He would subtract the $150 from the $1,000 and deduct the remaining $850. However, he would not have to report the $150 as income, so he effectively still got a full $1,000 deduction.

The arithmetic works this way up to a net interest deduction of $5,000. Above that level, net interest can be deducted only to the extent a taxpayer has investment income.

For example, suppose a taxpayer has paid $9,000 in interest other than on his home mortgage and received $2,500 in interest payments. He also has received $500 in dividends. His net interest paid is $9,000 minus $2,500, or $6,500. Of that, he can deduct $5,000 without question.

The remaining $1,500 worth of net interest payments must be adjusted according to the Treasury's fractional exclusion formula explained above. If the inflation rate for the year in question is 5 percent, the exclusion would be 45 percent, or $675. That leaves a potentially deductible net interest figure of $825.

But the taxpayer can, in general, deduct net interest payments above $5,000 only to the extent that he has net investment income. In this example, he had only $500 in investment income other than from interest, and he can deduct only that portion of his adjusted net interest payments. The remaining $325 he can carry forward to his next tax year, adding it to his other interest payments and deducting it if he meets the various tests for doing so. He would not have to adjust it a second time for the inflation exclusion.

Interest payments made in connection with a trade or business -- and that includes rental properties that are managed by the taxpayer -- are not subject to the investment income limitation. However, a portion of such payments must be excluded according to the Treasury's fractional exclusion formula.

For taxpayers with a vacation home that they rent, special rules apply. Under current law, all interest payments on a second home can be deducted regardless of how much the property is used by the owner, while most other deductions for expenses are not allowed if it is used by him or his family for more than 14 days each year.

Under the Treasury proposal, a portion of the interest paid on a second home used by the owner but also rented part of the time would be regarded as business income and not subject to the above limitations. The portion would be equal to the number of days the property is rented divided by the number of days in the year. That share of the interest payments would, of course, have to be reduced by the fractional exclusion before being deducted.

Any deduction of the remainder of the interest paid on such property would be subject to the investment income limitation.

While it affects relatively few taxpayers, there is already a limit on interest deductions related to earning investment income. The limit is $10,000 plus the amount of net investment income received. Consumer interest is fully deductible even though it is not likely to generate future income. So are interest payments made in connection with a trade or business even if the taxpayer is not active in the management of them.

The Treasury proposal would change the latter, which is a major feature of many tax shelters. Treasury would make interest paid to limited partners in partnerships and to shareholders of "S" corporations -- small, closely held corporations treated generally for tax purposes as if they were partnerships with income and deductions flowed through to the owners as individuals -- subject to the new investment income limitations.

Such a limitation would make many of the tax shelters no longer attractive to investors seeking to shield other income. In combination with the longer period for writing off most investments in equipment and buildings that the Treasury also wants to see, limiting interest deductions in this fashion should spell the end of many shelters.

For corporations, both interest received and interest paid would be subject to the fractional exclusion to offset inflation. That change, coupled with the new proposed deductibility of 50 percent of dividends paid, should push corporations to finance more of their operations with equity rather than debt.

The proposal to index interest payments and receipts for inflation would become effective Jan. 1, 1988, under the Treasury proposal.