Three Ways to Maximize Your Investment Interest Deductions
Ernie Neve, CPA
July 19, 2020
Here’s bad news—tax law allows you to deduct only some of the interest you pay on your debts.
For example, you do not deduct interest paid on your personal credit cards. Similarly, you may not deduct interest paid on the loan used to buy your personal vehicle.
But here’s good news—you likely aren’t deducting all the interest you can under the law.
One often overlooked deduction is for investment interest. And, sometimes, you get this deduction above-the-line with no limits.
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 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
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 your income from property you hold for investment (but not qualified dividends or long-term capital gains unless elected); plus
net short-term capital gain (ordinary income) from the sale or exchange of property you held for investment; less
deductible expenses (other than interest) directly connected with the production of investment income.
All that is a mouthful for sure. But it will become clear as you move ahead.
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.
1. 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
a home equity line of credit,
a credit card,
an unsecured loan, or
a loan secured against personal property.
Example. You take a home equity loan for $30,000 and spend it as follows:
$15,000 (50 percent) to buy a car for your child,
$7,500 (25 percent) to buy stock investments, and
$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 no dice 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. Recall that we had $1,200 of interest for the year. With tracing, you have
$600, or 50 percent, for your child’s car, which is non-deductible personal interest;
$300, or 25 percent, for stock investments, which is investment interest that you might deduct or carry forward on Schedule A; and
$300, or 25 percent, for business equipment, which is business interest that you deduct on Schedule C.
2. 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:
Carry over to next year the investment interest that’s not deductible this year.
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.
Planning tip. 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. Thus, 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.
Since making the election means choosing to pay ordinary tax rates instead of long-term capital gain rates on this income, consider the following to make sure you come out ahead:
Are you itemizing your Schedule A deductions so you will realize the full value of your investment interest deduction? If not, you could waste some or all of your election to treat qualified dividends and/or long-term capital gains as investment income.
With the election, you give up tax-favored income for an ordinary deduction. If you wait a year, can you have tax-favored treatment this year and ordinary deductions next year (the best of both worlds)?
If you won’t have any ordinary investment income in the near future to deduct the interest against, or only small amounts over many years, you should take the deduction now.
Example. In 2019, John had $3,000 of qualified dividend income. He carried over $1,000 in investment interest expense from tax year 2018. He is in the 24 percent tax bracket and itemizes deductions regardless of the investment interest deduction.
With no election, John can’t deduct the investment interest, and he pays $450 of federal tax on the dividends, which is 15 percent of $3,000.
If John elects to treat $1,000 of the dividends as investment income, he pays $300 in federal tax on the income, saving $150 ($540 - $240), as follows:
$540 of federal tax on the dividends, which is 24 percent of $1,000 plus 15 percent of $2,000, less
$240 tax savings from deducting the interest, which is 24 percent of $1,000.
3. Above-the-Line Deduction
If you buy a partnership interest or S corporation stock with a loan, you can usually deduct the interest on that loan above-the-line directly on your Schedule E.
To deduct 100 percent of the interest as an above-the-line deduction, you need to meet three requirements:
You have to materially participate in the entity’s business operations.
The entity must use its assets solely for conducting a trade or business activity and not for passive or portfolio activities.
The entity does not make debt-financed distributions to partners or shareholders.
Planning tip. Since the interest is attributable to the business, it is also a self-employment tax deduction for a partner in a partnership.
If you use loan proceeds to buy C corporation stock, then you’d deduct that as investment interest on Schedule A, subject to the investment interest limitations discussed above.
Example. Marie gets a $50,000 small-business loan to buy S corporation stock in an existing business. Marie is a full-time employee of the business.
For the year, Marie had $3,000 in ordinary net income from the S corporation and paid $4,000 in interest on her loan.
Marie can deduct the $4,000 directly on Schedule E against the $3,000 of net income. The deduction gives Marie a $1,000 ordinary non-passive loss that she can use against other income on her tax return.
If you have or are about to create investment interest and would like my input on how this works for you, please call me on my direct line at 1-888-ASK-NEVE.