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You probably know that the money you make on investments is taxable. For instance, dividends you’re paid on shares of stock generally have to be included in your gross income on your tax returns.
Sometimes, investors have to borrow money to buy the investment. And, like most other loans, you have to pay interest. So, if the money you make on the investment is taxable and you have to pay interest on the money you borrowed to buy the property, where’s the incentive to make future investments?
The deduction for investment interest expenses can help. The amount of the deduction is limited, but a limited deduction is better than no deduction at all. Save some money by checking to see if you can take it.
What’s “Investment Interest Expense”?
Investment income is your gross income from property you hold for investment. Investment property includes things like stocks, bonds, or anything else you might hold as an investment. Investment income includes things like interest, dividends, annuities and royalties.
Net investment income is the amount that your investment income exceeds your investment expenses. Investment expenses are costs you pay in connection with making money on your investment, like stock brokerage fees. For instance, if your investment income is $10,000 and your investment expenses equal $3,000, your net investment income is $7,000.
Investment interest expense, then, is the interest you pay on money you’ve borrowed to buy property that you hold for investment and will produce taxable income.
In order to understand how the deduction works, you need to know some other terms, such as:
- Capital gains and losses - gains or losses you make on the sale of a capital asset, such as stock
- Short-term capital gains and losses - gains or losses you make on the sale of a capital asset you held for one year or less
- Long-term capital gains and losses - gains or losses you make on the sale of a capital asset you held for more than one year
- Net capital gains - the amount that your net long-term capital gains exceed your short-term capital losses. These aren’t included in your investment income unless you elect to include them
Qualified dividends - dividends on stock you held for a certain period of time. These aren’t included in your investment income unless you elect to include them
The deduction is for investment interest only. So, if you borrow money for personal purposes as well as for investment, only the interest expense for the investment part is eligible for the deduction.
For example, if you borrow $10,000 and use $8,000 to buy investments and $2,000 for a vacation, only 80 percent of the interest on the loan is investment interest. The remaining 20 percent isn’t deductible.
How It Works
You can deduct investment interest expense up to the amount of your net investment income. If your investment interest expense is less than your net investment income, you can deduct the full amount. If your investment interest expense is more than your net investment income, you can carry forward the excess amount to a future tax year.
Figuring the deduction can be complicated, but some examples can help you see how it works.
Example 1: In 2010, you had investment interest expense of $10,000. During the year, you sold stocks two different times for a $10,000 long-term capital gain, and a $5,000 short-term capital loss. You choose to include your net capital gain ($5,000) as investment income. You have a net investment gain of $5,000 ($10,000 – 5,000). So, you can deduct only $5,000 of your investment interest expense in 2010. You can carry-forward the remaining $5,000 to 2011.
Example 2: In 2010, you had $9,000 of investment income, $8,000 of capital gains, $2,500 of investment interest expense, and $3,000 in brokerage fees. You choose not to treat any of the capital gains as investment income. Here, your net investment income is $6,000 ($9,000 – $3,000). You can deduct the full amount of your investment interest expense because it’s less than your net investment income.
Use Caution with Elections
Long-term capital gains (and qualified dividends), are taxed at much lower tax rates than regular income, such as wages. For 2010, the tax rate for long-term capital gains for most taxpayers is 15 percent. Ordinary income, however, is taxed up to 35 percent for most taxpayers.
If you elect to treat any of your qualified dividends or net long-term capital gains as investment income, the amount you elect doesn’t qualify for the lower tax rate. That may mean a higher tax bill because more of your income is being taxed at ordinary rates.
Invest in Your Return
If you have investments, it’s worth your time to see if you qualify for the deduction. The IRS has instructions and examples to help. Look them over carefully, and if you have any questions while preparing your return, talk to a professional tax preparer or a tax lawyer before you file.
Questions for Your Attorney
- I didn’t take a deduction in 2009 for my investment interest expenses. Can I use those expenses on my 2010 return? Should I file an amended 2009 return?
- Can I take the deduction if I and my spouse file separate returns?
- I have a carryover of interest income expense from 2009, but I have no interest income for 2010. Can I use the carryover on my 2010 return anyway?