By: John Pitlosh
By: John Pitlosh CFP®, MST
Understanding the investment interest deduction can pay big dividends. The purpose of this article is to get individuals up to speed on how the investment interest deduction works, and how it can benefit their own situation. Whether someone is looking to manage the tax consequences of a stock sale or they want to leverage their investment dollars, people borrow money to invest all the time. Even though investors use borrowed money to invest, most do not realize they can deduct the interest from these loans and even fewer understand how to comply with the deduction rules.
The starting point for the investment interest deduction is knowing that the source of the money isnt as critical as the purpose for the borrowed money. For example, if an investor take’s a margin loan from their investment portfolio to buy his girlfriend a car with the proceeds, the interest from this loan wont qualify as investment interest. However, if the investor borrows money from his credit card to buy Google stock, then the interest on his credit card bill due to the purchase of the Google stock would be deductible as investment interest.
Taking a loan to buy a stock and deducting the interest is pretty straight forward, but there are some types of borrowed investment purchases that will generate interest that wont qualify under the investment interest deduction rules due to specific exemptions outlined in the code and regulations.
- Tax Exempt Securities – Interest expenses attributable to the purchase of tax exempt securities like municipal bonds will not qualify for the investment interest deduction.
- Passive Activity Investments – Interest expenses related to a passive activity such as rental real estate are not considered investment interest, and they are covered by their own set of rules and regulations.
Once the interest can be traced to a qualified investment the next step is determining the amount of interest that is deductible in a given year. Since virtually everyone is a cash basis taxpayer, the investment interest is deducted in the year that the interest is actually paid. However, a cash basis taxpayer is not allowed to prepay interest for a future year and collect a deduction for the prepaid interest payment in the current year.
The amount of investment interest deduction that is allowed for any given year is limited to the amount of investment income that is produced in that year. For example, if taxpayer Mr. Xs available deduction for the year is $12,000 and he only has investment income of $8,000 than his deduction is limited to $8,000 for that year. Fortunately for Mr. X, the remaining $4,000 will carry over indefinitely until its used up.
Further complicating the matter is the requirement to subtract investment “non-interest” expenses from the total investment income. For example, if Mr. X had a miscellaneous itemized deduction worth $2,000 on his Schedule A then he would have to reduce his investment income from $8,000 down to $6,000 for the year. Non-interest investment expenses dont include expenses associated with a passive activities, so there is no need to factor passive activity expenses into your deduction limitations.
Investment Income & Practical Application
In general, investment assets that produce ordinary income are going to create income that can be offset by the investment deduction. Examples of ordinary income items include taxable interest, ordinary dividends, short term capital gains, annuity income, and royalties. Through a special election the scope of investment income can be expanded to include some or all of a taxpayers qualified dividends and long term capital gains. The special election to include qualified dividends and long term capital gains is made on IRS form 4952.
The special election gives investors a bonus opportunity for planning, because there arent many areas where capital gains intersect with ordinary income like they do with this deduction. In most cases, an individual wont want to convert a 15% capital gain into an ordinary income, but there are instances where it can make sense.
Example: Lets say our Mr. X has an adjusted gross income that is made up of $200,000 in wages. He also has $15,000 worth of qualified home mortgage interest than he will be deducting on his schedule A. Currently he has $30,000 of annual investment interest that he paid this year and he is going to sell his Apple stock with the $30,000 long term capital gain now that Steve Jobs is retired. If Mr. X makes the special election on form 4952 and applies all $30,000 of his interest deduction toward the capital gain then he can wipe out that gain and reduce his current federal income tax bill by $4,500 ($30,000 x 15%).
If you are like most taxpayers in this country that think all tax rates are going up then this type of planning will become more valuable.
Capital is usually scarce when investment and business opportunities are the most attractive. When investors see genuine opportunity they can act like hedge fund managers and obtain the loans they need through margin or other sources. When investors think outside the box to take advantage of these types of investor solutions they should always seek qualified advice.
1. IRS Publication 550
2. IRS Instructions for Form 4952