If you're an investor with interest expenses, rejoice -- you may be able to deduct them from your income, using IRS Form 4952 -- Investment Interest Expense Deduction.
In a nutshell, Form 4952 helps you determine for yourself -- and the IRS -- how much investment interest you can deduct on line 14 of Form 1040's Schedule A, as well as whether any can be carried forward onto a future tax return's itemized deductions. (You can only use the form and take the deduction if you're itemizing deductions.)
The reason you might have some sum to carry forward is because the amount you can deduct in a given year is limited to your net investment income for that year. Thus, if you have $2,000 in investment interest expense, and just $1,200 in qualifying investment income, you can only deduct $1,200 of interest, and will have to carry forward the remaining $800 into the next tax year's return.
Coming to terms
It will help to understand how Form 4952 works by reviewing some of the key terms related to it.
Investment interest: Investment interest is what you pay, or accrue, if you borrow money for investment purposes. Margin interest is a perfect example of this. When you invest with margin (or "on margin"), you essentially borrow money from your brokerage that you use for investments. Thus, you might have $100,000 of assets (stocks, funds, and cash, perhaps) in a brokerage account, and borrow $10,000 on margin with which to buy more stocks, funds, etc. For the privilege of borrowing that money, your brokerage will charge you interest -- investment interest.
Note that, even though you might think of your home as an investment, home mortgage interest is not considered investment interest, and is not deductible via Form 4952. (It is deductible, though, elsewhere on your tax return.) Form 4952 is also not appropriate if you borrow money for a business or for personal use. If you borrow a sum that you use for several purposes -- say, investments and personal use -- you can include the used-for-investment portion on Form 4952. Finally, investment interest tied to the purchase of tax-exempt investments, such as municipal bonds, or tied to the production of tax-exempt income, is not deductible. Obviously, credit card interest paid is also not deductible.
Net investment income: Investment income can come from interest you earn, dividends, annuities, royalties, capital gains -- and it typically cannot come from the operation of a profession or business or rental income from residential property. Two investment income items -- qualified dividends and long-term capital gains from the sale of investment property -- are generally excluded from your investment income calculations. You can choose to include them, but doing so might result in their no longer qualifying for lower tax rates, and being taxed at ordinary income tax rates. (Most people pay just a 15% tax rate on qualified dividends and long-term capital gains.) Consulting a tax pro here, or running the numbers both ways in tax-prep software such as TurboTax, is a good idea, to see which option is advantageous.
Note that the term is net investment income. That means the sum in question is what you have after you take your investment income and subtract your investment expenses.
Investment expense: Beyond interest, there are often other expenses related to your investments. These can include fees you pay to your tax preparer and investment advisors, fees paid to lawyers and accountants, the cost of a safety deposit box, and research materials such as financial magazines and newspapers. Even the depreciation of an asset used to produce investment income -- such as your computer --- can count.
What to do
Knowing about Form 4952 can help you prepare for tax season, as you'll know that you need to keep track of your investment interest expense, investment income, and investment expenses throughout the year. Even though Form 4952 looks quite straightforward, there are still a lot of rules and restrictions related to it. Be prepared to read the instructions closely, or enlist the services of a tax pro. It might seem costly to do so, but a good tax pro can often save you more than he or she costs -- and the expense can be deductible!
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