Investment Interest

Many of our clients are often confused when the subject of "deductible" interest is brought up. Many years ago, all interest (yes, for you younger readers, even credit card and auto loan interest) was available as an itemized deduction on your personal return.

However, after that law was changed and personal interest made nondeductible, many people do not realize that "investment interest" (interest paid on money borrowed to purchase property held for investment) is still deductible. 

Investment Property

Investment property is any property held for investment including property that produces interest, dividends, annuities, royalties or gains on disposition (land, etc). Investment property cannot be associated with a trade or business. Investment property is not limited to, but would include the following:

  ▪ Corporate stock
  ▪ Bonds and notes
  ▪ Mutual funds
  ▪ Any interest in a trade or business in which you do not materially participate

Limits On Deductibility

As with all interest deductions, investment interest must actually be "paid" during the year you intend to deduct it. Even if your broker has charged margin interest to your account, you cannot deduct that interest until the brokerage has actually taken the money from your account balance.  

Also, you cannot prepay interest on an investment for future years and take the deduction. You may only take the investment interest deduction in those years that the interest has actually accrued.

Investment interest is also deductible only to the extent that it offsets net investment income. Unfortunately, this rule tends to limit a lot of our clients in being able to deduct all of their investment interest.  

For example, if you borrow $20,000 to purchase a particular stock that your buddy has sworn is going to explode in value, you may find yourself unable to deduct the interest on that loan if you do not have sufficient interest and dividends or other investment income to warrant the deduction.

Net investment income means income net of any expenses incurred to obtain it. That means that even if you have interest and dividends, your net investment income that you can use to offset investment interest will be limited by any investment fees, publication expenses, etc that you incurred for the year.  

Disallowed investment interest can be carried over to following years so, in the example above, you could eventually offset the accumulated investment interest expense if you eventually sold the acquired stock at a gain large enough to offset it. 

Investment interest also cannot be deducted if it is interest on money borrowed to acquire or hold property that produces tax-exempt income. The most common tax-exempt properties would be municipal bonds or mutual funds that hold municipal bonds.

Allocation Of Your Investment Interest Expense

One common problem that most clients run into is the allocation of their interest expense between investment interest and personal interest. If you have borrowed money for both personal and investment purposes, you must allocate the debt and resulting interest expense among these different purposes.  

For example, if you borrow $10,000 and use $5,000 of the proceeds to purchase mutual funds and $5,000 to acquire a boat, only half of your interest expense from that debt will be allowed as investment interest.  

Unfortunately, it's seldom that easy in determining the proper allocation to make. For instance, if you later sell all or a portion of the stock you acquired with the debt and use the funds for personal or other reasons, the interest on the original debt will no longer be eligible as investment interest.  

Since many of our clients often move money around between accounts and for different purposes, the allocation of investment interest can get complicated very quickly.

There are steps you can take to ensure that your deduction is "clean" and not subject to challenge by the IRS. These steps involve setting up separate accounts, proper tracking and moving the money in a way that leaves no question as to how its being used.  

Please contact us in advance if you have investment loans that you would like to use for other purposes. There are also many strategies you may be able to take advantage of if you have investment interest and potential capital gains to offset them. We can assist you in working through some of the pitfalls and opportunities.