Investment Interest Expense

Investment interest expense is interest paid or accrued on a loan whose proceeds are properly allocable to property held for investment. Section 163(d)(3) of the Internal Revenue Code calls it "investment interest" and excludes two kinds of interest that have their own rules: qualified residence interest on a home mortgage, and interest taken into account in figuring income or loss from a passive activity such as a rental.

The phrase sometimes appears in ordinary speech to mean interest you earn on investments. In tax usage it means the opposite: interest you pay to invest. The interest you earn is part of the investment income that limits the deduction.

The limit. For individuals, estates and trusts, section 163(d)(1) says the deduction for investment interest "shall not exceed the net investment income of the taxpayer for the taxable year". Net investment income is investment income minus investment expenses. Investment income includes taxable interest, nonqualified dividends, annuity income and royalties from property held for investment, and short-term gains from selling investment property. The limit stops borrowed money from producing a deduction against wages or business income while the investment's return is deferred or taxed at lower rates.

The carryforward. Under section 163(d)(2), interest disallowed in one year is treated as investment interest paid in the next year, and so on, with no expiration. It becomes deductible in a year when net investment income is large enough to absorb it.

The election for qualified dividends and capital gains. Qualified dividends and net long-term capital gains from investment property are left out of investment income unless the taxpayer elects to include them, on line 4g of Form 4952. Whatever is elected stops qualifying for the lower capital gains rates and is taxed at ordinary rates. So the election trades a lower rate on those dollars for a larger interest deduction now, and it only pays when the interest deduction is worth more than the rate difference given up. Once made, the IRS says, the election can be revoked only with its consent.

What does not count. The rules follow the use of the borrowed money, under allocation regulations that trace loan proceeds. Interest on a margin loan used to buy a car is personal interest, which is not deductible, even though stocks secure the loan. Interest on debt used to buy or carry tax-exempt municipal bonds is disallowed by section 265 and is not investment interest at all. Interest on a loan used in an active business is business interest, with its own rules.

Investment expenses now. Investment expenses are deductions other than interest directly connected with producing investment income, such as depreciation on an investment asset. Advisory fees and similar costs used to be miscellaneous itemized deductions; those are now permanently disallowed under section 67(h), so they no longer count as investment expenses either, which leaves net investment income higher and the interest limit easier to meet.

Two different "net investment income" figures. The 163(d) figure is not the same as the base for the 3.8% net investment income tax under section 1411, although investment interest that is deductible reduces both.

1. Identify the interest. Total the interest paid on debt whose proceeds went into investments, including any carryforward from last year. Exclude mortgage interest, passive-activity interest, interest tied to tax-exempt bonds and interest on borrowed money used for personal purposes.

2. Figure investment income. Add taxable interest, nonqualified dividends, annuity and royalty income from investment property, and short-term gains on investment property. Decide whether to elect any qualified dividends or long-term gains into the total.

3. Subtract investment expenses allowed as deductions, such as depreciation on investment property.

4. Deduct the lesser of the interest and net investment income on Schedule A, through Form 4952, and carry the rest forward. Form 4952 is not needed in the simplest case, where interest and ordinary dividend income (minus qualified dividends) exceed the interest, there are no other investment expenses and there is no carryover.

For example: Lena itemizes and is in the 24% bracket. She pays $7,000 of margin interest on a loan used to buy stocks. Her investment income is $1,500 of bank interest and $500 of nonqualified dividends, plus $4,000 of qualified dividends and $6,000 of long-term gains taxed at 15%.

Without the election, her net investment income is $2,000, so she deducts $2,000 (saving $480 at 24%) and carries $5,000 forward. If she elects $5,000 of her dividends and gains into investment income, she deducts the full $7,000 (saving $1,680), but that $5,000 is taxed at 24% instead of 15%, costing $450. The election is worth $750 this year ($1,680 minus $480, minus $450), but she then has no carryforward left to deduct in a later year.

Pros

• Interest on money borrowed to invest is deductible at all, unlike interest on personal debt.
• Disallowed interest carries forward indefinitely, so it is postponed rather than lost.
• The election lets an investor whose income is mostly dividends and gains use the deduction now when that is worth more.

Cons

• Only itemizers benefit; with the standard deduction, the interest saves nothing.
• The limit means a heavily borrowed investor can deduct little while investment income is low.
• Electing qualified dividends or gains into investment income gives up their lower tax rate, and the election is hard to undo.
• Tracing rules decide the character of the interest by how the money was used, so mixing personal and investment borrowing can turn deductible interest into nondeductible interest.