Deductible Investment Interest Expenses

Editorial team of TFX

• 29.03.22 • 5 min read

Many miscellaneous itemized deductions were terminated by the Tax Cuts and Jobs Act (TCJA) from 2018 to at least 2025. However, there was one deduction that was not eliminated and it was the investment interest deduction. Individual taxpayers can still use Schedule A of their Form 1040 tax returns to claim investment interest charges as an itemized deduction. 

This post by TFX highlights what the investment interest deduction is and how you can qualify for that.

What is Investment Interest Deduction?

The federal tax code has a variety of incentives designed to incentivize investments. Among these is the investment interest deduction. When you borrow money to purchase a piece of real estate for investment purposes, the interest on the loan becomes an "investment interest expenditure." 

For instance, suppose you obtain a $5,000 loan on your home equity and utilize the proceeds to purchase stock. That loan's interest is investment interest. (It would not be deducted as mortgage interest because the money was not used to purchase, construct, or upgrade your home.) If you invest only a fraction of the borrowed amount, you can deduct only a proportionate share of the interest paid.

Having understood what investment interest deduction is and finding an affirmative answer to the question  “is investment interest deductible?” Let's move on to what qualifies as an investment interest deduction.

What Qualifies As Investment Interest Deductible?

Considering that increasing your tax deductions can significantly minimize your tax burden, let's take a look at some of the common deductible investment expenses that you may reduce investment taxes.

Investment Interest Expense

You may be eligible to deduct your investment interest costs if you itemize your deductions. This comprises margin loans for stock purchases in a brokerage account. In these cases, you may qualify for a deduction on margin loan interest. However, if you spent the loan to purchase tax-advantaged investments like municipal bonds, this wouldn't apply. 

Deductible Investment Interest Expense

Can you deduct investment interest expenses? The answer is yes. To compute your deductible investment interest expense, first determine your net investment income. This usually comprises common dividends and interest income but excludes investment income taxed at lower capital gains rates, such as qualifying dividends or municipal bond interest that is not taxed.

Now, compare your investment interest expenses to your net investment income. If your expenses are less than the net investment income, you can deduct your entire investment interest expense. If your interest expenses exceed your net investment income, you can deduct them up to that amount. The remaining costs will be carried over to the following year.

For instance, suppose Steve earns $150,000 in total income, $8,000 in investment income (ordinary dividends and interest), $10,500 in investment interest charges on a margin loan, and $13,000 in itemized deductions (such as state taxes and mortgage interest). Steve's taxable income has been lowered from $150,000 to $129,000 as a result of the investment interest itemized deductions.

Qualified Dividends

For the purpose of the investment interest expense deduction, qualified dividends that obtain preferential tax treatment are not considered investment income. However, you can choose to get your qualified dividends classified as ordinary income.

In the right set of circumstances, treating qualified dividends like ordinary dividends might improve your investment interest deduction, allowing you to pay 0% tax on the payouts rather than the 15% to 20% tax that qualified dividends usually receive. Here's how it could operate in practice.

In addition to the facts in the first example, suppose Steve had $2,000 in qualifying dividends that he would ordinarily pay $300 in taxes on ($2,000 x 15% tax rate). If Steve chose to classify the qualifying dividends as ordinary income, his net investment income might increase from $8,000 to $10,000. As a result, he'd be able to deduct a larger portion of his investment interest expense this year — and the qualified dividends would be tax-free. Steve was able to lower his taxable income from $150,000 to $127,000 since he is a tax-savvy investor. The deduction for investment interest expenses of $10,000 resulted in a tax savings of $2,220. (Assuming a 24 percent ordinary tax rate and a 15 percent long-term CGT rate).

Capital Loses

It is never a pleasant experience to take a monetary loss. However, there is a positive side to it. You can use capital losses to offset capital gains. If your capital losses exceed your capital gains, up to $3,000 of your capital losses can be brought to use to offset regular income and thus reduce your tax burden (or $1,500 if married and filing separately). Over $3,000 in net losses can be rolled forward to offset profits in future tax years. 

However, make sure to keep records of your investment cost basis to make the most efficient use of capital losses. The cost basis of an investment is often equal to the purchase price of the asset plus any acquisition costs, such as transaction fees and commissions.  The cost basis is used to decrease your taxable gain when you sell your investment.

Conclusion

Although these are all legit ways to reduce your burden of investment interests, you should be careful while dealing with the IRS. For example, the decision to regard qualified dividends as regular dividends must not be taken lightly. Once the decision is made, it can't be revoked without the IRS's consent. Therefore, before executing any of these tax strategies, consult with a tax professional.