Investment interest — interest paid on debt used to purchase non-business investment property that produces interest, dividends, royalties or will produce gain or loss from the sale or trade, such as stocks and bonds, mutual fund shares, limited partnership units or real estate (not rental property) — has a long definition, we know. But it's deductible, which means you really ought to know about it.
The most common type of investment interest is “margin interest” on a brokerage account.
The deduction for investment interest is limited to “net investment income," which includes income from property held for investment, dividends that do not qualify for the special capital gains tax rates, royalties and net short-term capital gains. Net long-term capital gains are not considered investment income for purposes of deducting investment interest. Deductible investment expenses, such as those allowed as a miscellaneous deduction on Schedule A, are subtracted from investment income to determine the “net investment income” limitation.
Any excess investment interest that can't be deducted in the current year because of this income limitation is carried forward and deducted on future tax returns.
If you use a margin loan for anything other than the purchase of additional investments, to buy a car for example, the resulting margin interest will be considered personal interest and not investment interest and therefore will not be deductible. The IRS applies special “tracing” rules to track the use of loan proceeds and determine how to classify the interest.
New Jersey tax pro Robert D. Flach has been preparing 1040s for individuals since 1972.