When you borrow money to buy assets held for investment, any interest you pay on that loan is called “investment interest expense”. In some cases, you can deduct this expense—see if you qualify.

What qualifies for the investment interest deduction?

Not all interest you pay on investment loans is deductible. You can only take a deduction for investment interest expenses when the assets you buy produce taxable income, such as interest, dividends, capital gains or royalties. In other words, if you use that borrowed money to buy assets that generates tax-free income, you are not allowed to take a deduction.

For example, let’s say you borrowed $5,000 to invest in municipal bonds and received tax-exempt interest income of $250. Since you don’t pay tax on your income, you cannot take investment interest expense deduction.

Is there a cap on your deduction?

There is. You can only take the deduction up to the amount of your net investment income. Any disallowed deduction will be carried over for future use. To calculate your net investment income, you can use the following formula:

Taxable Interest
+ Nonqualified Dividends
+ Short-term Capital Gains
- (Investment-related miscellaneous deduction from Schedule A)

= Net investment Income

An election can be made to include long term capital gain and qualifying dividends in investment income in order to allow a larger amount of interest investment interest expense to be claimed. This requires that the long-term capital gain and qualifying dividends be taxed at ordinary income tax rates.

How can you take the deduction?

In order to take the deduction you must itemize your deductions because investment interest deduction goes on Schedule A. You will also need to file Form 4952. If you don’t itemize, unfortunately you will not get any benefit from this deduction.

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If you need more information, please contact our team. We can help you evaluate the tax costs and benefits of these investments.