Investment Interest

This section discusses the interest expenses you may be able to deduct as an investor.

If you borrow money and use it to buy property you hold for investment, the interest you pay is investment interest. You can deduct investment interest subject to the limit discussed later. However, you cannot deduct interest you incurred to produce tax-exempt income. Nor can you deduct interest expenses on straddles.

Investment interest does not include any qualified home mortgage interest or any interest taken into account in computing income or loss from a passive activity.

Investment Property

Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also includes an interest in a trade or business activity in which you did not materially participate (other than a passive activity).

Partners, shareholders, and beneficiaries. To determine your investment interest, combine your share of investment interest from a partnership, S corporation, estate, or trust with your other investment interest.

Allocation of Interest Expense

If you use borrowed money for business or personal purposes as well as for investment, you must allocate the debt among those purposes. Only the interest expense on the part of the debt used for investment purposes is treated as investment interest. The allocation is not affected by the use of property that secures the debt. However, fully deductible home mortgage interest is not treated as investment interest and the debt does not have to be allocated, regardless of how the proceeds are used.

Limit on Deduction

Generally, your deduction for investment interest expense is limited to the amount of your net investment income.

You can carry over the amount of investment interest that you could not deduct because of this limit to the next tax year. The interest carried over is treated as investment interest paid or accrued in that next year.

You can carry over disallowed investment interest to the next tax year even if it is more than your taxable income in the year the interest was paid or accrued.

Net Investment Income

Determine the amount of your net investment income by subtracting your investment expenses (other than interest expense) from your investment income.

Investment income. This generally includes your gross income from property held for investment (such as interest, dividends, annuities, and royalties). Investment income does not include Alaska Permanent Fund dividends.

Choosing to include net capital gain. Investment income generally does not include net capital gain from disposing of investment property (including capital gain distributions from mutual funds). However, you can choose to include all or part of your net capital gain in investment income.

You make this choice by completing line 4e of Form 4952 according to its instructions.

If you choose to include any amount of your net capital gain in investment income, you must reduce your net capital gain that is eligible for the lower capital gains tax rates by the same amount.

Before making this choice, consider the overall effect on your tax liability. Compare your tax if you make this choice with your tax if you do not.

Investment income of child reported on parent’s return. Investment income includes the part of your child’s interest and dividend income that you choose to report on your return. If the child does not have Alaska Permanent Fund dividends or capital gain distributions, this is the amount on line 6 of Form 8814, Parents’ Election To Report Child’s Interest and Dividends.

Child’s Alaska Permanent Fund dividends. If part of the amount you report is your child’s Alaska Permanent Fund dividends, that part does not count as investment income. To figure the amount of your child’s income that you can consider your investment income, start with the amount on line 6 of Form 8814. Multiply that amount by a percentage that is equal to the Alaska Permanent Fund dividends divided by the total amount on line 4 of Form 8814. Subtract the result from the amount on line 6 of Form 8814.

Child’s capital gain distributions. If part of the amount you report is your child’s capital gain distributions, that part generally does not count as investment income. However, you can choose to include part of it in investment income. Use a worksheet in chapter 3 of Publication 550 to figure the amount to include on line 4a of Form 4952.

Investment expenses. Investment expenses include all income-producing expenses (other than interest expense) relating to the investment property that are allowable deductions after applying the 2% limit that applies to miscellaneous itemized deductions. Use the smaller of:

1. The investment expenses included on line 22 of Schedule A (Form 1040), or
2. The amount on line 26 of Schedule A.

Losses from passive activities. Income or expenses that you used in computing income or loss from a passive activity are not included in determining your investment income or investment expenses (including investment interest expense). See Publication 925, Passive Activity and At-Risk Rules, for information about passive activities.

Form 4952

Use Form 4952, Investment Interest Expense Deduction, to figure your deduction for investment interest.

Exception to use of Form 4952. You do not have to complete Form 4952 or attach it to your return if you meet all of the following tests.

• Your investment interest expense is not more than your investment income from interest and ordinary dividends.
• You have no other deductible investment expenses.
• You have no disallowed investment interest expense from 1999.

If you meet all of these tests, you can deduct all of your investment interest.

More Information

For more information on investment interest, see Investment Expenses in chapter 3 of Publication 550.

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