There are various types of interest expense, including qualified residence interest, passive interest, and business interest. Each set has its own set of rules that allow for deductibility. In this article we are discussing investment interest.
Investment interest is interest you pay on loans to hold investment property. That seems reasonable, right? But investment property does not mean just real estate. It can also be property held for investment that produces income not derived in the ordinary course of a trade or business. It also includes property that produces a gain or loss not derived in the ordinary course of a trade or business from the disposition of property that produces these types of income or property that is held for investment. However, it does not include an interest in a passive activity.
It does not include interest that you pay for your main home, second home, rental income property, or property you might use in your trade or business. Some of these things might seem like investments, but you must 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 does not. Margin interest is nothing more than a type of investment interest and is subject to all of the regulations for investment interest.
You can deduct investment interest up to the amount of net investment income received. You report this on Schedule A, Itemized Deduction, using Form 4952, Investment Interest Expense Deduction, 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, annuities, royalties, investment income reported to you on Schedule K-1 from a partnership or S corporation, net investment income from an estate or a trust, 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 to treat net long-term capital gains as investment income. You can stick with business as usual and have your long-term capital gains taxed at their preferential tax rate. If you do that, you cannot 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 net long-term capital gains as investment income. That way those net 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. Also, this is a binding decision and cannot be rescinded.
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 into your crystal ball to see what the future might bring. Just do not 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.
The rules for investment interest deduction can be complicated—especially if the transactions involved are complicated. If you use the loan proceeds for something other than purchasing investment property (such as rental property interest or business property interest), the rules get even more complicated. You’ll likely have to deal with the interest tracing rules and interest reallocation rules.
If you decide to borrow against investment property you hold—and hope to deduct the interest—you must be careful and completely understand the rules. If you would like any further information regarding this issue as well as any other tax related issue, please contact Henssler Financial at 770-429-9166 or experts@henssler.com.
