The Investment Interest Expense Deduction
Investors who borrow money to invest may be able to deduct their loan interest
Individual taxpayers can claim investment interest expenses as an itemized deduction on Schedule A—at least through tax year 2017. The Tax Cuts and Jobs Act, the tax reform law that was signed into law in December 2017, eliminates this deduction beginning in 2018 through at least 2025.
It's not too late to claim the deduction if you've already filed your 2017 return. You have three years from the date you filed to submit an amended tax return or two years from the date you paid any taxes due on that return, whichever is later. Some elections must be made within six months of the filing date, however.
What Is Investment Interest?
Investment interest is interest paid on a loan where the proceeds were used to purchase property you held for investment. According to the Internal Revenue Service, "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."
In other words, if you take out a loan to buy stocks, interest on that loan can be deducted as investment interest. Investment interest should also be deducted when you're calculating the 3.8 percent 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. It can't exceed that amount.
Investment income "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," according to the IRS.
How to Calculate Your Investment Income
Investment income means investment income minus investment expenses other than any interest expenses only for purposes of calculating the investment interest deduction. You can determine your net investment income by subtracting your investment expenses not including your interest expense from your investment income.
Investment expense deductions can include accounting fees, legal fees, fees for automatic investment services, fees for investment advice, and safe deposit box costs.
The Capital Gains Election
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 of your qualified dividends and net capital gains you want to include in net investment income on line 4(g) of Form 4952.
The effect of this election is that qualified dividends and net capital gains included in net investment income are taxed at ordinary tax rates, not at the lower long-term capital gains tax rates. But 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."
This election must be made on a "timely filed" tax return—that is, a return filed by the extended due date for the year or in April if you did not ask for an extension of time to file. Taxpayers can amend a previously filed return to make this election within six months of the original due date. After it's made, the election can be revoked only with the consent of the Internal Revenue Service.
How to Claim the Deduction
Investment expenses are a miscellaneous itemized deduction on Schedule A of Form 1040. They're subject to the 2-percent rule—you can only claim the deduction for expenses that exceed 2 percent of your adjusted gross income. Enter them on line 14 of the 2017 Schedule A.
You might or might not have to include Form 4952 as well. The IRS advises in Publication 550 that it's not necessary to file Form 4952 if you meet all of the following tests:
- "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"
You can deduct all your investment interest if you qualify. But remember, this deduction is only available through the 2017 tax year. The TCJA expires at the end of 2025, so the deduction might return at that time.