Question: Can you go over the investment interest expense deduction?

https://www.irs.gov/pub/irs-pdf/p550.pdf

Page 32-34 (Interest Expenses).

What is the investment interest expense deduction?

If you borrow money to finance investments, the interest you pay is considered investment interest. Examples include margin interest your broker charges you on loans to buy stocks, and interest you pay on money you borrowed to buy raw land for speculation. If you have investment interest expense, you can deduct it up to the amount of your net investment income.

Investment interest expense is the interest on money you borrow to purchase taxable investments. It’s tax deductible up to the amount of any net investment income, and leftover investment interest expense can be carried over for use in future years, without expiration.

It’s not the source of the loan that matters for tax deduction purposes; it’s how you use the money. Here are a few examples of what you might buy with a margin loan, and whether the interest will be deductible:

  • Stocks: Loan interest is deductible.

  • Tax-exempt municipal bonds: Loan interest is NOT deductible.

  • Car: Loan interest is NOT deductible.

To calculate your net investment income—and therefore how much investment interest expense you can deduct—add up your taxable interest income, ordinary dividends, long-term capital gains and qualified dividends if you make a special election to treat them as ordinary income (more below).

For example: Say you have $11,000 of investment interest expenses and $10,000 of taxable investment income. You could use $10,000 of investment interest expenses to offset all the investment income and carry forward the remaining $1,000 of unused investment interest expense to offset income in a future tax year.

How do the qualified dividend rules affect investment interest expense?

  • Qualified dividends. Qualified dividends that receive preferential tax treatment aren’t considered investment income for purposes of the investment interest expense deduction.2 However, you could elect to treat qualified dividends as ordinary income (similar to net long-term capital gain income) to boost the amount you can deduct as investment interest expense. The advantage here is that you pay 0% tax on qualified dividends rather than 15% or 20% tax.

    Let’s go back to our example: If you also have $1,000 of qualified dividends, you could pay 15% or 20% tax on them, or you could elect to treat those dividends as ordinary income. This would allow you to deduct the full $11,000 of investment interest expense in the current year.

  • Payment in lieu of dividends. If you buy dividend-paying stock on margin and your broker lends out the stock, you don’t really receive dividends, you receive payment in lieu of dividends. These payments are treated as ordinary income and aren’t eligible for the qualified dividend rate, but they are eligible to offset your investment interest expense, so all is not lost. However, if you already have sufficient ordinary investment income from other sources (or more payment in lieu of dividends than can be used), you’re stuck with ordinary tax treatment.

Do I qualify for the investment interest expense deduction?

Eligibility requirements

 - You must be an investor who borrows money to buy investments, and receives interest, dividends, capital gains, royalties, or other investment income.

 - You must itemize your deductions on Schedule A.

Limitations of this deduction

You can deduct interest expense only up to the amount of your net investment income. Your net investment income is your investment income minus investment expenses (other than interest expense). Examples of investment expenses include safe deposit box fees, investment advisory fees, and the cost of investment publications, such as magazine subscriptions. Investment expenses also include depreciation and depletion of assets that produce investment income (such as a computer), and investment expenses reported to you on a Schedule K-1 from a partnership or an S corporation.

 - You can deduct any interest expense that is greater than your net investment income. You deduct it from next year's interest income, and then carry forward any remaining amounts to future years.

 - If you borrow for business or personal purposes as well as investment, you can deduct only the interest expense on the part borrowed for investment purposes.

 - You can deduct only interest that you actually pay. You cannot deduct interest that is added to the amount you owe, such as life insurance loan interest added to the loan principal.

 - You cannot deduct prepaid interest you pay in the current tax year that is not actually due until future tax years.

 - Limits apply if you borrow to buy treasury bills or market discount bonds.

You generally cannot deduct:

 - Interest on loans to buy tax-free securities such as tax-exempt bonds

 - Personal interest, credit card fees, loan fees, and credit investigation fees

 - Interest expenses related to a passive activity such as rental real estate, or a limited partnership or S corporation that you're not actively involved in

 - Interest related to options straddle strategies

Special circumstances

Investment interest income includes the following:

 - Portfolio income (dividends, royalties, or interest from non-business activities) received as a partner of a limited partnership or a shareholder of an S corporation (even where you're not actively involved). These are reported separately on the Schedule K-1 statement you receive.

 - Interest or royalties from a working interest in oil and gas wells and partnerships

 - Interest received from an estate or trust

 - Your child's dividends and interest that you choose to report on Form 8814, Parent's Election to Report Child's Interest and Dividends

 - If you have qualified dividends and net capital gains, you can include it as part of investment income in order to be able to deduct more of your investment interest expense in the current year. But if you do so, these dividends and long-term capital gains will be taxed at regular tax rates instead of the lower capital gains rates.


What paperwork do I need for the investment interest expense deduction?

Keep the following for your records:

 - 1099-INT forms you receive from banks and lenders

 - 1099-DIV forms and Form 1099-B (Proceeds from Broker and Barter Exchange) from mutual funds and securities firms

 - Schedules K-1 from partnerships (Form 1065) and Schedules K-1 from S corporations (Form 1120S)