15.10 Investment Interest Limitations
Interest paid on margin accounts and debts to buy or carry other investments is deductible on Schedule A up to the amount of net investment income. If you do not have investment income such as interest, you may not deduct investment interest. Investment income for purposes of the deduction generally does not include net capital gains or qualified dividends, but you may elect to include them in order to increase your investment interest deduction. If you make the election, the elected amount will not be eligible for the favorable capital gain rates; see “Computing the Deduction” below. Investment interest in excess of net investment income may be carried forward and deducted from next year’s net investment income.
You compute the deduction for investment interest on Form 4952, which must be attached along with Schedule A to Form 1040.
What is investment interest?
It is all interest paid or accrued on debts incurred or continued to buy or carry investment property such as interest on securities in a margin account. However, interest on loans to buy tax-exempt securities is not deductible (15.11).
Investment interest does not include interest on qualifying home acquisition debt (15.2) or home equity debt (15.3), production period interest that is capitalized (16.4), or interest related to a passive activity (10.8).
Investment property includes property producing portfolio income (interest, dividends, or royalties not realized in the ordinary course of business) under the passive activity rules discussed in Chapter 10, and property in activities that are not treated as passive activities, even if you do not materially participate, such as working interests in oil and gas wells.
Caution
Passive activity interest is not investment interest.
Interest expenses incurred in a passive activity such as rental real estate (10.1), or a limited partnership or S corporation in which you do not materially participate (10.6), are taken into account on Form 8582 when figuring net passive income or loss. This includes interest incurred on loans used to finance your investment in a passive activity. Do not treat passive activity interest as investment interest on Form 4952.
However, interest expenses allocable to portfolio income (non–business activity interest, dividends, or royalties) from a limited partnership or S corporation are investment interest and not passive interest. The investment interest will be listed separately on Schedule K-1 received from the partnership or corporation.
Computing the Deduction
Deductible investment interest is limited to net investment income. Net investment income is the excess of investment income over investment expenses. The key terms investment income and investment expenses are defined below.
Investment income.
Investment income is generally gross income from property held for investment, such as interest, dividends, other than qualified dividends, annuities, and royalties. Income or expenses considered in figuring profit or loss of a passive activity (10.8) is not considered investment income or expenses. Property subject to a net lease is not treated as investment property, as it is within the passive activity rules.
If you have net capital gains (net long-term capital gains exceeding net short-term losses) from the sale of investment property such as stocks or mutual-fund shares, or capital gain distributions from mutual funds, such gains and distributions are not treated as investment income unless you specifically elect to include them in investment income on Form 4952. You may elect to include all or part of them. The same election rule applies to qualified dividends (4.1) that are subject to net capital gain tax rates. An election must be made on Form 4952 to include qualified dividends in investment income. If you make this election, you may not apply preferential capital gain rates (5.3) to the amount of the net capital gains (and capital gain distributions) or qualified dividends treated as investment interest on Form 4952. If you make the election on Form 4952, the elected amount is subtracted from net capital gains when applying the capital gain tax rates on the IRS worksheets (5.3).
Investment expenses.
There are expenses, other than interest, directly connected with the production of investment income. However, for purposes of determining net investment income, only those investment expenses (other than interest) allowable after figuring the 2% floor for miscellaneous itemized deductions (19.1) are taken into account. The 2% floor will bar a deduction for some of the miscellaneous itemized deductions. For purposes of this net investment income computation, assume that miscellaneous itemized deductions other than investment expenses are disallowed first.
Net investment income.
Reducing investment income by investment expenses gives you net investment income. Your deduction for investment interest expenses is limited to this amount; any excess interest expense for 2012 may be carried over to 2013, as discussed below.
Caution
Where to enter the deduction on your return.
The deduction figured on Form 4952 is generally entered on Schedule A as investment interest. However, if the interest is attributable to royalties, you may have to enter the interest on Schedule E; follow the Form 4952 instructions. Furthermore, there is an additional complication if you have investment interest for an activity for which you are not “at risk” (10.18). After figuring the investment interest deduction on Form 4952, you must enter the portion of the interest that is attributable to the at-risk activity on Form 6198. The amount carried over to Form 6198 is subtracted from the investment interest deduction claimed on Form 4952.
Carryover to 2012 and future years.
Investment interest in excess of net investment income for 2012 may be carried forward to 2013 and is deductible in 2013 to the extent that when added to 2013 investment interest expenses it does not exceed net investment income. If not used in 2013, the carryforward extends indefinitely to 2014 and future years.