If you borrow money to buy investment assets, the IRS will sometimes allow you to deduct the loan’s interest from the taxable income the investments generate. This is called the investment interest expense deduction. While it applies only to income – not long-term capital gains – it can help lower your taxes under the right circumstances. Consider talking with a financial advisor with tax expertise if you need help optimizing your tax strategy.
What Is the Investment Interest Expense Deduction?
If you take a loan to buy investment assets, any interest that you pay on that loan is called an “investment interest expense.” Under some circumstances, the IRS allows you to deduct investment interest expenses from the income those assets produce. This is known as the investment interest expense deduction.
For example, say that you borrow $30,000 to buy bonds that issue a regular interest payment. The interest on that loan would be considered an investment interest expense, lowering the taxable income the bonds generate. The same is true if you borrowed $10,000 and used that money to purchase stocks. The interest on that loan would be considered an investment interest expense. By contrast, if you borrow money to buy a car, the interest on the loan would not be considered an investment interest expense
It’s important to note that using borrowed money to buy assets like equities, options or similar securities carries significant risk. This practice is known as “leveraging,” and it can potentially lead you to lose all of the money that you borrowed.
When Can You Take the Investment Interest Expense Deduction?
The investment interest expense deduction allows you to deduct your interest payments on qualified investments from the taxable income that those assets generate.
What Can You Claim?
You can claim this deduction for any loan that you use to buy taxable investment assets. For example, if you buy a portfolio of stocks with borrowed money, the interest payments on that loan would be eligible for this deduction if you sold the stocks within one year of purchasing them.
On the other hand, if you take out a loan to buy municipal bonds, you would not be able to take the deduction for those interest payments. The deduction only applies to taxable assets, and municipal bonds are tax-exempt.
Finally, a common issue with the investment interest expense deduction arises when investors take out a loan to purchase rental properties and related physical investment assets. The IRS does not allow you to apply this deduction to income generated by a rental property, such as a house or apartment.
What Can You Deduct?
You can apply this deduction to investment income that’s subject to income tax rates. Specifically, it applies to interest, ordinary dividends, annuities and royalties. It does not apply to returns that are taxed at capital gains rates, such as long-term stock sales, nor does it apply to business or passive income.
This can effectively cap your deduction. You can deduct your interest expenses from your qualified investment income for the year, again meaning any returns and yields that are taxed at income tax rates. This applies to all qualified interest payments, so even if you used the loan to buy long-term assets, this deduction can lower the taxable income (dividends, for example) that those assets produce.
However, if you paid more interest than you collected in income, your deduction will be effectively capped. In this case, you can apply the remainder to next year’s taxes.
Finally, this is a below-the-line deduction, meaning you can only take it if you itemize your taxes.
Investment Interest Expense Deduction: An Example
Say that you have the following portfolio:
- A $10,000 loan to buy bonds, with $500 of interest
- A $20,000 loan to buy stocks, with $1,000 of interest
- $800 in dividend payments from your bonds
- $1,500 in long-term capital gains from selling stocks
You would calculate your deduction as follows:
- Total investment interest expenses: $1,500
- Investment income: $800
- Deduction: $800 – $1,500 = $0
You have $1,500 of investment interest expenses, because both your stocks and your bonds are taxable assets. However, you only have $800 worth of investment income. The stock sales don’t count, since they were taxed as long-term capital gains.
The result is that you can deduct your interest payments from the investment income, reducing that all the way down to nothing. Since you paid more in interest than you can claim in deductions, you can apply the remaining $700 to next year’s taxes.
In the alternative, you can elect to have long-term capital gains taxed as ordinary income. Under most circumstances, that’s a bad idea, since investments are taxed at a lower rate than earned income. However, if you have significant interest expenses, it may help lower your taxes. Take our example above. If you elect to have your stock sales treated as income, you would have the following deduction:
- Total investment interest expenses: $1,500
- Investment income: $2,300 ($800 of dividends + $1,500 of elected capital gains)
- Deduction: $2,300 – $1,500 = $800
By electing to have your stock sale taxed as income, you can deduct far more from your total returns. Depending on your tax brackets, this can sometimes result in an overall advantage.
The investment interest expense deduction allows you to deduct the interest that you pay on a loan that’s used to buy taxable investment assets. It applies only to investment income, not long-term capital gains.
Tax Tips for Investing
- A financial advisor can help you better understand the tax implications of different investments, and potentially, help you lower your tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- While the investment interest expense deduction can help you lower your taxable income, there are also several ways to lower your investment portfolio’s tax liability. Choosing long-term investments will mean you’ll pay long-term capital gains tax instead of the higher income tax rates. You can also use tax-deferred retirement accounts to invest with more tax efficiency. Lastly, selling off losing investments and using those losses to offset gains can lower your tax bill.
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