Interest paid on personal loans is generally not tax-deductible. Most tax filers are aware of the exceptions for mortgage interest and student loan interest. However, there is another type of interest deduction available to individual investors who borrow funds to make certain types of investments.
Individuals can sometimes justify borrowing money at a low-interest rate in order to potentially earn a greater return. The investment interest deduction is only applicable to investments that are currently taxable and not tax-deferred. Therefore, the deduction cannot be taken to secure funding for most types of retirement accounts. The deduction is used for investments in corporate bonds, stock, or mutual funds.
Itemized deductions
The deduction for investment interest is an itemized deduction, reported on IRS Schedule A along with other types of itemized deductions. The investment interest deduction is easy to overlook since it is reported on Schedule A in a different category than other investment expenses. Consequently, the deduction for investment interest has different limitations than other types of investment expenses.
Miscellaneous deductions category
Expenses for professional advice and investment periodicals are miscellaneous itemized deductions. Certain miscellaneous deductions, including investment advice, are deductible only to the extent their total exceeds 2 percent of adjusted gross income, which is a figure from your Form 1040. As a result, those miscellaneous itemized deductions are effectively not fully utilized.
Interest deduction category
Investment interest is reported on Schedule A in the same category as mortgage interest. In fact, there is an entry line near the end of the interest category designated solely for investment interest. The amount of your deductible investment interest cannot exceed the related investment income, so you may need a separate form to calculate the exact amount of the interest deduction.
Form 4952 calculation
IRS Form 4952 is used to reduce your total investment interest expense by any qualified dividends that were taxed at a reduced tax rate. Your total interest amount must also be reduced by any gains on the sale of stock that received preferential capital gain rates. Form 4952 also reduces your interest deduction by the amount of any miscellaneous investment expense that is actually deductible.
Form 4952 provides the option to forgo the preferential treatment of qualified stock dividends or capital gains. By doing so, your total investment interest deduction is not reduced accordingly. It is best to calculate the deduction both ways and choose the method that provides the best overall outcome.
If your total investment expense is greater than the allowable deduction calculated on Form 4952, the excess is carried forward to the next tax year. Contact a financial planner for more advice on how tax-deductible interest can help you achieve your investment objectives.
Contact a company like Family Financial Partners for more information and assistance.
