Investment Interest and Margin Interest
By Roy Lewis
There are various types of interest expense, including qualified residence interest, passive interest, and business interest. Each type has its own set of rules that allow for deductibility. In this article, we're discussing investment interest.
Investment interest is interest you pay on loans to hold investment property. That seems reasonable, right? But, investment property doesn't just mean real estate. It can also be stocks, or bonds, or other securities or property -- any type of investment property, either real or personal, that you are holding for investment purposes.
It doesn't include interest that you pay for your main home, second home, rental income property, or property that you use in your trade or business. Some of these things might seem like investments, but you've got to understand that "investment property" is a technical term that only applies to specific property. This is a very important distinction, and one that you should be able to make.
Many of you are familiar with the term "margin" interest -- the interest your broker charges you when you borrow against your brokerage account. You might think that margin interest has its own set of rules, but it really doesn't. Margin interest is nothing more than a type of investment interest, and is subject to all of the rules and regulations for investment interest.
We'll discuss this in more detail in a minute, but there is a situation where margin interest is not considered "investment interest" for tax purposes -- when you borrow on margin against your brokerage account and use the money for a non-investment purpose. (Again, we'll explain the whys and wherefores shortly... for now, just understand that how you use the money you borrow matters to Uncle Sammy.)
You can deduct investment interest up to the amount of net investment income received. You report this on Schedule A using Form 4952 as a back-up computation. Defining net investment income can get a bit tricky. In general, it includes gross income from investment property (such as interest, dividends, short-term capital gains, and elected long-term capital gains), less any investment expenses (which might include expenses for investment publications and similar things).
You have to make an additional decision for long-term capital gains. You can stick with business as usual and have your long-term capital gains taxed at their preferential tax rate. But, if you do that, you can't use any of those long-term gains as investment income to offset investment interest expense.
You can elect to treat all or some of your long-term capital gains as investment income. That way, those long-term gains can be used to offset investment interest expenses. The downside? You lose the ability to have those long-term gains taxed at the preferential capital gains tax rates.
The Long-Term Gain Election
If you're confused, we're not surprised. Electing to treat long-term gains as investment income is a difficult concept to understand. So, let's take a closer look.
Net investment income doesn't include long-term capital gain income (i.e., gain from investment and capital assets held for more than one year). But, you can elect to treat all or part of your long-term net capital gains as investment income -- as long as you subtract it from the amount eligible for the preferred long-term capital gains tax rate. In other words, if you elect to treat X dollars of long-term capital gain as investment income, you must decrease your long-term capital gains by X dollars.
This is an important choice to make... and you really should be aware of the impact.
Example: Consider Lois, a single person with the following income and expenses:
If Lois does not treat any capital gains as investment income, she can only deduct investment interest expenses up to the amount of her net investment income (in this case, she only gets to deduct $3,000 of her $5,000 in investment interest expenses).
- Interest Income.....$3,000
- Long-Term Capital Gain.....$6,000
- Investment Interest Expense.....$5,000
- Other Itemized Deductions.....$10,000
So, she deducts $3,000. The total she owes in taxes, using the Schedule D worksheet, amounts to $16,834. What happens to the rest of the investment interest expense beyond the $3,000? Lois will carry that $2,000 forward to the next tax year, and it will be available as an investment interest expense deduction as long as she has net investment income in the next tax year.
Note that Lois ends up losing the ability to deduct that last $2,000 on her current tax return. To avoid this, she can elect to treat $2,000 of her $6,000 in long-term capital gains as investment income. Doing so means the full $5,000 of investment interest expense is deductible, and her tax (according to the Schedule D worksheet) is $16,434. No investment interest expense is carried over to the next tax year. So, the election saved Lois $400 in taxes for the year.
Would it have been more beneficial for Lois not to make the election, and simply carry over the $2,000 of investment interest to the following year? It depends on a number of factors, including her anticipated net investment income and long-term capital gains for the next year.
While making the election could save you tax dollars in the short run, it might cost you tax dollars in the long run. Your best bet is to gaze deeply into your crystal ball to see what the future might bring. Just don't forget that, in many cases, a bird in the hand really is worth more than two in the bush. You are generally better off making the election and reducing your taxes today. But, that might not be true for everyone, so make sure to review your specific situation to see what is best for you.
Investment Interest Myths, Tips, and Traps
There are a number of misconceptions and potential traps regarding investment interest, and especially so with margin interest. Here are four of the biggies, along with the true story for each of them:
1. Under no circumstances can you take your margin interest and add it to the cost basis of your stock... or reduce the sale price of your stock by the amount of margin interest that you paid... or claim this interest as a miscellaneous itemized deduction on Schedule A... or use it to reduce your interest income on Schedule B. The only places where investment interest can be claimed are on Form 4952 and/or on Schedule A. Even then, the only way this interest is deductible is if it meets the rules noted above.
2. If your investment interest expense is due to money you borrowed for a tax-free investment (such as tax-exempt bonds), you can't deduct it. You can only deduct it if the investment generates taxable income. So, don't margin your portfolio to buy tax-free bonds and look forward to a big margin interest expense deduction. It won't be available to you.
3. You must itemize your deductions to receive the tax benefit of investment/margin interest paid. But, even if you do use the standard deduction, if you find that you have excess investment interest, you can still use Form 4952 to compute your excess investment interest and carry over any excess to the next tax year.
4. If you use the borrowed funds for something other than to purchase additional investment property, the interest you pay will not be considered investment interest for tax purposes. It may or may not be deductible depending on what type of interest it is and the different rules that apply, but it won't be investment interest. As an example, say that you borrow against your portfolio and use those funds to take a pleasure trip to Lower Albania. The interest you pay on those funds will be treated as non-deductible personal interest. The key is not that you paid interest on the borrowed funds, but how those funds were used.
Still Holding Your Interest?
The rules for the investment interest deduction can be complicated -- especially if the transactions involved are complicated. And, if you use the loan proceeds for something other than purchasing investment property (such as Schedule E rental property interest, Schedule C business interest, etc.), the rules get even more complicated. You'll likely have to deal with the interest tracing rules and interest reallocation rules.
So, if you decide to borrow against investment property you hold -- and hope to deduct the interest -- you must be careful and understand the rules completely. Your minimum required reading would include IRS Publications 550 and 535, and IRS Form 4952 and the associated instructions. You'll be glad you did.