If you borrow money to make an investment, the interest on the loan is deductible—in most cases. As usual, the law includes exceptions and limitations to keep you on your toes.
First, the exceptions. For the interest to be deductible, the investment has to be designed to produce taxable income. Interest on a margin loan from your broker to invest in stocks or taxable bonds qualifies. But if the borrowed money is used to invest in tax-exempt securities, the interest is not deductible. Ditto if you borrow to buy a single-premium life insurance policy or annuity. Congress doesn't want the IRS subsidizing loans to help you purchase tax-favored investments.
If you borrow to invest in a passive activity, the interest is an expense of the passive activity—and thus is deductible only to the extent of passive income.
Investment interest is deducted on Schedule A with your other itemized deductions. But in almost all cases you must also file Form 4952, on which you compute the allowable deduction and, if necessary, what part of your expense must be carried over to future years.
There is a limit to how much investment interest you can deduct. Basically, the write-off is restricted to the amount of taxable investment income you report. But not all taxable investment income counts. Because long-term capital gains get their own special break—a tax rate of just 15% (5% for those in the 10% or 15% bracket) — Congress says they don't count as income for purposes of determining how much investment interest you can deduct. Ditto for dividends, which also now enjoy the sweet 15%/5% rates. Congress doesn't want you writing off interest in the 35% bracket, for example, if the income associated with the loan is only being taxed at 15%.
Any investment interest you are unable to deduct because of the cap is not lost forever. It may be carried over to future years and deducted as soon as there is sufficient investment income to offset it, or on the final tax return after your death.