Investment Interest Deduction
You can deduct investment interest to the extent you have net investment income.
Investment interest is any interest you pay or accrue on debt allocable to your property held for investment, which includes:
1.) property that produces portfolio income, such as interest, dividends, annuities, royalties, and gain or loss on the sale or exchange of property producing such income; and
2.) any interest in any trade or business activity that isn’t a passive activity and in which you don’t materially participate.
Your net investment income is
1.) your income from property you hold for investment (but not qualified dividends or long-term capital gains unless elected); plus
2.) net short-term capital gain (ordinary income) from the sale or exchange of property you held for investment; less
3.) deductible expenses (other than interest) directly connected with the production of investment income.
We know all of that is a lot to think about. But it will become clear as you move forward.
If you don’t have enough investment income to deduct all your investment interest, then you carry forward any unused investment interest to the next tax year.
Now that you have the big picture, let’s examine three ways to maximize the benefits.
- Take Advantage of Tracing Rules
The tax code’s so-called tracing rules allow you to allocate your interest expense based on how you use the proceeds of the loan.
With tracing, your investment interest could come from
1.) a home equity line of credit,
2.) a credit card,
3.) an unsecured loan, or
4.) a loan secured against personal property.
Example. You take a home equity loan for $30,000 and spend it as follows:
1.) $15,000 (50 percent) to buy a car for your child,
2.) $7,500 (25 percent) to buy stock investments, and
3.) $7,500 (25 percent) to buy equipment for your Schedule C business.
For the year, you pay a total of $1,200 in interest on the home equity loan.
The Tax Cuts and Jobs Act disallowed home mortgage interest deductions for home equity loans that were not used to buy, build, or improve your residence.
Okay, so that has ended as a tax deduction for home-equity interest. Let’s go to Plan B and trace the loan interest so we can find some deductions. Remember that we had $1,200 of interest for the year. With tracing, you have
1.) $600, or 50 percent, for your child’s car, which is non-deductible personal interest;
2.) $300, or 25 percent, for stock investments, which is investment interest that you might deduct or carry forward on Schedule A; and
3.) $300, or 25 percent, for business equipment, which is business interest that you deduct on Schedule C.
- Make the Investment Interest Election
Remember, you can deduct investment interest to the extent you have net investment income. What if you are short on the investment income part? You have two choices:
1.) Carry over to next year the investment interest that’s not deductible this year.
2.) Make an election to include qualified dividend income and net long-term capital gain as investment income so you can enable some or all of the interest deduction.
Preparation idea. Don’t include more than you need, because when you make this election, you lose the tax-favored status granted to the dividends and long-term capital gains. Therefore, you come out ahead when you enable the interest deduction offset, but any excess puts you behind.
You make the election by including the amount you select on line 4g of Form 4952, Investment Interest Expense Deduction.