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By: John Pitlosh
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 won't 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 won't 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.