Understanding the Investment Loan Interest Deduction
Good to Know
Can you deduct the interest you pay on loans used to make investments? Conventional wisdom would have you believe the rules are complex. Yet, we only need to address the following three questions to gain clarity.
- What kinds of interest paid on investment loans are deductible?
- How do dividend income and capital gain impact the deduction? and
- What limits apply to the deduction?
What Kinds of Interest Paid on Investment Loans Are Deductible?
Interest paid on debt used to acquire investments is investment interest; it is conditionally deductible as an itemized deduction in an individual income tax return (different rules apply to business deductions). Here’s the condition—investment interest is deductible only to the extent that income or net capital gains from the investment are taxed at ordinary income tax rates. So, for example, interest paid on debt used to acquire the following investments is not tax-deductible:
- Municipal bonds—the bonds pay tax-exempt income interest,
- Securities that generate long-term capital gains when sold, and
- Straddles or passive activities.1
Put your “IRS hat” on for a moment. Interest is deductible only if the investment generates income or gains taxed at ordinary income tax rates. Why? Because itemized deductions reduce the taxpayer’s taxable income subject to ordinary income tax rates. The IRS will not allow a taxpayer to take a deduction against ordinary income for interest paid on an investment that generates income tax-free income (muni bonds) or capital gains taxed at preferential long-term capital gain rates.
Ironically, taxpayers with deductible investment interest have no assurance of an income tax benefit. Once again, why? The investment interest deduction reduces a taxpayer’s income tax only if the taxpayer itemizes deductions. A taxpayer claims itemized deductions only if total itemized deductions exceed the standard deduction. So here’s the point—deductible investment interest generally provides no income tax benefit if the taxpayer claims the standard deduction.2
Let’s take a moment and understand how dividend income and capital gains fit within the deduction framework.
How Do Dividends and Capital Gains Impact the Deduction?
Dividends
Dividends can be qualified or nonqualified. Qualified dividends are taxed at long-term capital gain rates, while nonqualified dividends are taxed at ordinary income tax rates. Note the following distinguishing factors:
- Qualified dividends are dividends paid from U.S. domestic corporations3 on shares of stock owned for a required holding period,4 and
- All other dividends are generally nonqualified.
Logically enough, interest paid on debt used to acquire shares of stock that pay nonqualified dividends (taxed at ordinary income tax rates) is deductible within annual limits. But interest paid on debt used to acquire stock that pays qualified dividends is not deductible.
Noteworthy
The IRS considers certain dividends as taxable interest income, not true dividends. Examples include REIT dividends, Money Market Fund dividends, and dividends paid on deposits with financial institutions. Interest paid on debt used to acquire investments that generate interest income taxed at ordinary income tax rates is generally tax-deductible within an annual limit.
Capital Gains
Ordinary income tax rates apply to net short-term capital gain; hence, interest paid on debt used to acquire the underlying investment is tax-deductible. In contrast, long-term capital gain rates apply to net long-term capital gains; thus, interest paid on debt used to acquire the underlying investment is not tax-deductible.
What Limits Apply to the Deduction?
Any single year’s maximum investment interest deduction is limited to the taxpayer’s net investment income (NII). The IRS defines NII as investment income taxed at ordinary income tax rates less certain related investment expenses. An example follows.
| Net Investment Income for Investment Interest Deduction | ||||
| Investment | Interest Income or Recognized Gain | Income/Gain Type | Account Management Fees | Net Investment Income |
| Municipal Bonds | $2,000 | Tax-free | $50 | $0 |
| Stock | 11,000 | Short-term capital gain | 2,900 | 8,100 |
| REIT | 1,550 | Taxable Interest | 50 | 1,500 |
| Total | $14,550 | $9,600 | ||
The NII from the municipal bond is zero because tax-free interest is excluded from NII. The only capital gain transaction for the year produced an $11,000 short-term capital gain. Net short-term capital gain less account management fees (an investment expense) is considered NII.
Marie paid the following in interest on loans used to purchase the investments in the preceding chart:
| Investment | Interest Paid on Investment Acquisition Debt | Conditionally Deductible Interest Paid |
| Stock | $15,000 | $15,000 |
| Muni Bonds | $1,500 | $0 |
| REIT | $250 | $250 |
| Total | $15,250 |
Marie’s conditionally deductible interest paid is $15,250 in the current year, but not all of it is currently deductible. As a result, her current-year itemized investment interest deduction is limited to the NII of $9,600. However, the deduction for the disallowed interest paid of $5,650 ($15,250 - $9,600) may not be lost. The $5,650 is carried forward to future years until there is sufficient net investment income to allow the deduction.5
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide tax, legal, compliance or financial advice. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
1 Exceptions apply.
2 A separate tax (the 3.8% Net Investment Income Tax) can be reduced for certain upper-middle-income and high-income taxpayers even if the taxpayer does not itemize deductions.
3 Certain foreign corporations may also qualify.
4 Shares must be held for at least 61 days during the 121 days that begin 60 days before the stock’s ex-dividend date.
5 If the taxpayer in this example had qualified dividends, they could have elected ordinary income tax treatment for the qualified dividends. This strategy would have allowed a larger current year investment interest deduction.
