Investment interest is interest on money you borrow specifically for buying property you hold for investment. This includes (among other things) stocks, bonds, and land or other investment property. This doesn’t include straddles or anything that yields tax-exempt income (such as municipal bonds, life insurance, or annuities). If the loan comes from a broker, it is usually referred to as a margin account.
If you used part of a mortgage refinance loan, or a home equity loan (or line of credit) to buy the property, the interest on that loan doesn’t count towards investment interest. Nor does investment interest include any interest related to a passive activity.
There are rules that limit the amount of investment interest you can deduct. If you borrow money and use part of it for investment purposes, then you must allocate the interest between the various uses. The allocation is based on how much of the loan is used for each purpose.
Example: You borrow $10,000, and use 20% ($2,000) of it for investments and 80% ($8,000) to pay off your credit cards. In the first year of the loan, you pay a total of $600 in interest. Of the $600 you paid, $120 (20%) of it is investment interest, which you can deduct. The rest of the interest ($480) isn’t deductible.
You can’t deduct interest that you haven’t paid. That may seem obvious, but if you know how much interest you will be paying, you can’t deduct that interest even if it applied to a loan you had during the year.
Example: You took some money out of your margin account in November 2007, and plan to pay off the loan by the end of February 2008. By the end of 2007, two months of interest will have accrued, but because the brokerage doesn’t charge you for the interest until the loan is repaid, you can’t deduct the interest. When the loan is paid off in February 2008, you’ll receive a statement from your broker reporting the margin interest you received. Since you’ll be reporting this income on your 2008 tax return, you’ll be able to deduct the interest at that time.
The amount of investment interest that you can deduct can’t be more than the amount of investment income that you report. For purposes of this deduction, investment income is defined as interest, dividends, short-term gains, royalties, and so forth.
Generally, you can’t deduct qualified dividends or long-term capital gains because you’re already getting a tax break on them since they’re taxed at a lower rate (15% / 5%) than ordinary income. However, if you designate qualified dividends or long-term capital gains as investment income when you prepare your taxes, you can then deduct the interest paid on them.
Once you decide to do this; however, you can’t take advantage of the lower tax rates that qualified dividends and long-term capital gains usually receive. They will now be taxed at the same rate as all your other income. The advantage of doing this is that you’ll have more investment interest to deduct. However, if you decide not to allocate any of the qualified dividends or long-term gains to ordinary income, you can carry over any investment interest expense that you couldn’t use. You need to decide which option will give you the least amount of tax liability.
Example: You have investment interest expense of $2,400. Your investment income consists of interest of $1,300, qualified dividends of $750, and long-term capital gains of $2,000. The total amount you can deduct is $1,300, ignoring the qualified dividends and the long-term capital gains. You have $1,100 of remaining investment interest. You can choose to have $1,100 of the qualified dividends and long-term capital gains treated as investment income. If you do it, you’ll have a deduction of $2,400, but only $1,650 will be taxed at the reduced rates for qualified dividends and long term capital gains.
You deduct investment interest on Schedule A with your other itemized deductions. To deduct investment interest, you’ll need to file a Form 4952 with your return. On this form, you calculate the amount of investment interest that you can deduct, as well as the amount to be carried over to future years (if any). Also, this is where you designate the amount of qualified dividends and long-term capital gains that you want to treat as investment income. If you use the interview to enter your investment income expenses, TaxCut will make sure that your expenses are correctly reported on the form and carried over to Schedule A. Be sure to enter all your investment income before you go through the Deductions section of the interview.
For more information, see IRS Publication 550, Investment Income and Expenses.