Investment Interest Expense Deduction
Investors who borrow money to invest may be able to deduct their loan interest.
Individual taxpayers can deduct investment interest as an itemized deduction on Schedule A.
Investment interest is interest paid on a loan where the proceeds were used to purchase property held for investment. "Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss" (Publication 550).
For example, a person takes out a loan to buy stocks. Interest on that loan can be deducted as investment interest.
Investment interest is also deducted when calculating the 3.8% unearned income Medicare contribution tax on net investment income.
Limitations on the Deduction
The amount of interest that can be deducted in any particular year is limited to the taxpayer's net investment income for that same year.
Investment income, for the purpose of the investment interest expense deduction, "includes your gross income from property held for investment (such as interest, dividends, annuities, and royalties). Investment income does not include Alaska Permanent Fund dividends. It also does not include qualified dividends or net capital gain unless you choose to include them" (Publication 550).
Only for the purpose of calculating the investment interest deduction does investment income mean investment income minus investment expenses other than any interest expenses.
In Publication 550, the IRS advises, "Determine the amount of your net investment income by subtracting your investment expenses (other than interest expense) from your investment income."
Taxpayers can elect to include qualified dividends and net capital gains in the calculation of net investment income for the year for the purpose of deducting investment interest.
This election is accomplished by choosing how much qualified dividends and net capital gains to include in net investment income on Form 4952 line 4g.
The effect of this election is that qualified dividends and net capital gains included in net investment income are taxed at ordinary tax rates and not at the lower long-term capital gains tax rates. Another effect of this election is that you could have higher net investment income, and thus a higher deduction for investment interest. The IRS advises, "You should consider the tax effect of using the qualified dividends and capital gains tax rates before making this election" (Instructions for Form 4952).
This election must be made on a timely filed tax return (that is, a return filed by the extended due date.) Taxpayers can amend a previously filed return to make this election within six months of the original due date. The election, once made, can be revoked only with the consent of the Internal Revenue Service. See the Instructions for Form 4952 for details on how to make this election.
Investment expenses, for the purpose of calculating the investment interest expense deduction, include "your allowed deductions (other than interest expense) directly connected with the production of investment income.
Investment expenses that are included as a miscellaneous itemized deduction on Schedule A (Form 1040) are allowable deductions after applying the 2% limit that applies to miscellaneous itemized deductions" (Publication 550). Such investment expense deductions include accounting and legal fees, fees for automatic investment services, fees for investment advice, and safe deposit box fees. Refer to the Expenses of Producing Income section of Publication 550 for details about the types of investment expenses that can be deducted.
Where to Deduct Investment Interest Expenses
Investment interest expenses are deducted as an itemized deduction on Schedule A (found on line 14 of the 2012 version). In some circumstances, you may also need Form 4952. The IRS advises that Form 4952 is not needed in the following circumstances:
"Exception to use of Form 4952. You do not have to complete Form 4952 or attach it to your return if you meet all of the following tests.
"If you meet all of these tests, you can deduct all of your investment interest" (from Publication 550).
- "Your investment interest expense is not more than your investment income from interest and ordinary dividends minus any qualified dividends.
- "You do not have any other deductible investment expenses.
- "You have no carryover of investment interest expense from [the previous year].