Investors are allowed to deduct interest expense they pay on debt incurred to purchase or carry property held for investment. Property held for investment includes any property producing interest, dividends, annuities, royalties, and gain-generating property other than that used in a business.
How the Investment Interest Expense Deduction Works
Investment interest is deductible as an itemized deduction. It is limited to net investment income. Net investment income is defined as investment income that exceeds investment expenses. Investment income includes interest and includes gains that are not subject to the reduced capital gains tax rate (e.g., short term capital gain taxed at ordinary rate is qualifying investment income while long term capital gain taxed at 15% is not qualifying investment income). Also excluded from qualifying investment income are qualified dividends subject to the lower capital gains tax rates. An election exists whereby a taxpayer can treat qualifying dividends and capital gains as ordinary income and treat such income as qualifying investment income in order to deduct investment interest expense, but this election generally won’t be beneficial.
Watch Out for Tax Exempt Securities
Investment interest does not include interest expense incurred to purchase tax-exempt securities, so such interest expense is not deductible. This rule also applies to mutual funds so if a fund invests in both taxable and tax-exempt securities, the interest expense must be allocated proportionally based on the income in the fund.
Because expenses allocated to tax-exempt securities are not deductible, the allocation of expenses to tax-exempt income should be minimized. While it is common to allocate investment expenses to taxable and non-taxable income based on the amount of income in each category, allocating the interest expense in a different manner (such as the number of transactions or the amount of time spent on each class of income) may provide larger allocations to taxable income and therefore increase the amount of deductible investment interest expense.
Example: Danny manages his own investments. He trades very frequently, but hasn’t been successful this year. His taxable investment income is $5,000 and his tax-exempt investment income is also $5,000. If he allocated investment interest expense based on the relative amount of income from each class, only half of his investment interest expense would be deductible. However, if 90% of his time in his investment activities is managing his taxable investments and 10% of his time is spent managing his tax-exempt investments, then he has a strong case that 90% of his investment interest should be deductible.
Taxpayers who receive tax exempt income must submit with their returns an itemized statement showing the amount of each class of exempt income and the expenses allocated to each class. If an item is allocated between tax-exempt and taxable income, the basis of the allocation must be shown on the statement.
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.