OVERVIEW
If you borrow money to purchase an investment, you may qualify for a tax break. The IRS allows certain taxpayers to take a tax deduction for the interest expense on some loans using Form 4952. However, the tax ramifications of investment interest can be complicated, as the IRS only allows a deduction for certain types of investment interest. Additionally, the Alternative Minimum Tax (AMT) could completely disallow the use of your investment interest deduction.
Investment interest expense and income
One of the most common examples of investment interest expense involves the use of a margin loan at a brokerage. If you "go on margin" with your stockbroker, it means you're borrowing money from the firm to buy stocks or other investments. The interest you pay on that margin loan is qualifying investment interest.
You can only take a deduction for investment interest expenses that is lesser than or equal to your net investment income. For example, if you have $3,000 in margin interest but net investment income of only $1,000, you can only deduct the $1,000 in investment interest in the current year.
The IRS does allow you to carry forward the disallowed deduction into future years, however. In this example, you can use the $2,000 in disallowed expenses for this year in a future year, but the same restrictions continue to apply. You must have net investment income to deduct qualifying investment interest.
Investment interest expense limitations
Not all interest you pay on investment loans is allowed as a deduction. The IRS specifically prohibits certain types of investment interest from qualifying, including the following:
- qualified home mortgage interest
- interest used to generate tax-exempt income, such as if you go on margin to buy a municipal tax-free bond
- option straddles, which are an advanced investment strategy not applicable to most investors
- interest taken into account when computing the gain or loss on any passive activities
Alternative Minimum Tax (AMT)
Thanks to the Alternative Minimum Tax, if you fill out one Form 4952, you'll always have to complete a second one for AMT calculations. The AMT is designed to ensure that certain individuals pay at least a minimum amount of tax by adding back in items that may have been excluded from a traditional tax calculation.
Investment interest is one of those deductions disallowed under the AMT. The instructions for Form 4952, "Investment Interest Expense Deduction," and Form 6251, "Alternative Minimum Tax—Individuals," instruct taxpayers on how to compute the correct taxes under both systems. Ultimately, whichever of your Form 4952s shows the higher tax is the one you will have to file with the IRS.
Using Form 4952
Although the rules for calculating investment interest expense deductions may be complicated, Form 4952 itself is quite short and divided into these three sections:
- Part I consists of three lines on which you'll calculate your total investment interest expense
- Part II is where you'll enter your gross income from property held for investment; after a few adjustments outlined in the instructions for the form, you'll arrive at your net investment income on line 6
- Part III serves two purposes—calculation any disallowed expense that you can carry forward to future years and determining your net investment interest expense deduction for the current year on line 8. This final amount is what you transfer to Schedule A to be used as an itemized deduction on your taxes.
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