If you borrow money to invest, the interest you pay may be deductible. The investment interest deduction can offset part of the tax on your investment income. Here is how it works and how to claim it.
What counts for the investment interest deduction?
Investment interest is interest on money you borrow to buy property held for investment. For example, margin interest on a brokerage account usually qualifies. Similarly, if you take a home equity loan and use the money to buy stock, the interest may count as investment interest. What matters is how you use the borrowed money.
The investment must produce taxable investment income, such as interest, ordinary dividends or annuities. By contrast, interest on money used to buy tax-exempt bonds is not deductible.
How much you can deduct
Your deduction can’t exceed your net investment income for the year. However, any interest you can’t deduct carries forward to future years. So you don’t lose it.
By default, qualified dividends and long-term capital gains don’t count as investment income for this limit. However, you can elect to include them. In that case, you give up the lower tax rates on those amounts. So run the numbers before you choose.
What doesn’t qualify
- Passive activities. Interest on money used for a business you don’t materially participate in is generally treated under the passive activity rules instead. For example, a loan to buy a stake in a friend’s company where you aren’t involved day to day.
- Tax-exempt investments. As noted above, interest tied to tax-exempt income isn’t deductible.
- Personal loans. Interest on money used for personal spending doesn’t qualify.
How to claim the investment interest deduction
You claim the deduction only if you itemize on Schedule A. In most cases, you also file Form 4952, Investment Interest Expense Deduction.
However, you may skip Form 4952 if all three of these are true:
- Your investment income from interest and ordinary dividends, minus qualified dividends, is more than your investment interest.
- You have no other deductible investment expenses.
- You have no disallowed investment interest carried over from last year.
Get help with investment interest
Tracing loans and choosing whether to include capital gains can change your tax bill. To review your situation, call (415) 842-2940 or book a free 15-minute call.