Publication 550 |
2000 Tax Year |
Interest Expenses
This section discusses interest expenses you may be able to deduct
as an investor.
For information on business interest, see chapter 5 of Publication 535.
You cannot deduct personal interest expenses other than qualified
home mortgage interest, as explained in Publication 936,
and interest
on certain student loans, as explained in Publication 970,
Tax
Benefits for Higher Education.
Investment Interest
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. See Tax-exempt income under Nondeductible
Expenses, later. Nor can you deduct interest expenses on
straddles, also discussed under Nondeductible Expenses.
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.
Example 1.
You borrow $10,000 and use $8,000 to buy stock. You use the other
$2,000 to buy items for your home. Since 80% of the debt is used for,
and allocated to, investment purposes, 80% of the interest on that
debt is investment interest. The other 20% is nondeductible personal
interest.
Debt proceeds received in cash.
Interest you pay on debt proceeds that you received in cash is
generally treated as nondeductible personal interest. However, you can
treat any payment you make within 30 days before or after you receive
the proceeds as made from those proceeds. This applies to any payment
(up to the amount of the proceeds) made from any account you own, or
from cash. Also, you can treat the payment as made on the date you
received the cash instead of on the date you actually made the
payment.
Debt proceeds deposited in account.
If you deposit debt proceeds in an account, that deposit is treated
as an investment expenditure. Amounts held in the account are treated
as investment property, regardless of whether the account bears
interest. Any interest you pay on the deposited proceeds is investment
interest. But, if you withdraw the funds and use them for another
purpose, you must reallocate the debt and any interest you pay.
Example 2.
Assume in Example 1 that you borrowed the money on March
1 and immediately bought the stock for $8,000. You did not buy the
household items until June 1. You had deposited the $2,000 in the
bank. You had no other transactions on the bank account and made no
principal payments on the debt. The $2,000 is treated as being used
for an investment purpose for the 3-month period. Your total interest
expense for 3 months on this debt is investment interest. In June, you
must begin to allocate 80% of the debt and the interest expense to
investment purposes and 20% to personal purposes.
Payments on debt require new allocation.
As you repay the debt, you must reallocate the balance. You must
first reduce the amount allocated to personal purposes by the
repayment. You then reallocate the rest of the debt to find what part
is for investment purposes.
Example 3.
If, in Example 2, you repay $500 on November 1, the
entire repayment is applied against the amount allocated to personal
purposes. The debt balance is now allocated as $8,000 for investment
purposes, and $1,500 for personal purposes. Until the next
reallocation is necessary, 84% ($8,000 x $9,500) of the debt
and the interest expense is allocated to investment.
Pass-through entities.
If you use borrowed funds to buy an interest in a partnership or S
corporation, then the interest on those funds must be allocated based
on the assets of the entity. If you contribute to the capital of the
entity, you can make the allocation using any reasonable method.
Additional allocation rules.
For more information about allocating interest expense, see chapter 5 of Publication 535.
When To Deduct
Investment Interest
If you use the cash method of accounting, you must pay the interest
before you can deduct it.
If you use an accrual method of accounting, you can deduct interest
over the period it accrues, regardless of when you pay it. For an
exception, see Unpaid expenses owed to related party under
When To Report Investment Expenses, later in this chapter. Example.
You borrowed $1,000 on September 6, 2000, payable in 90 days at 12%
interest. On December 5, 2000, you paid this with a new note for
$1,030, due on March 5, 2001. If you use the cash method of
accounting, you cannot deduct any part of the $30 interest on your
return for 2000 because you did not actually pay it. If you use an
accrual method, you may be able to deduct a portion of the interest on
the loans through December 31, 2000, on your return for 2000.
Interest paid in advance.
Generally, if you pay interest in advance for a period that goes
beyond the end of the tax year, you must spread the interest over the
tax years to which it belongs under the OID rules. You can deduct in
each year only the interest for that year.
Interest on margin accounts.
If you are a cash method taxpayer, you can deduct interest on
margin accounts to buy taxable securities as investment interest in
the year you paid it. You are considered to have paid interest on
these accounts only when you actually pay the broker or when payment
becomes available to the broker through your account. Payment may
become available to the broker through your account when the broker
collects dividends or interest for your account, or sells securities
held for you or received from you.
You cannot deduct any interest on money borrowed for personal
reasons.
Deferral of interest deduction for market discount bonds.
The amount you can deduct for interest expense you paid or accrued
during the year to buy or carry a market discount bond may be limited.
This limit does not apply if you accrue the market discount and
include it in your income currently.
Under this limit, the interest is deductible only to the extent it
is more than:
- The total interest and OID includible in gross income for
the bond for the year, plus
- The market discount for the number of days you held the bond
during the year.
Figure the amount in (2) above using the rules for figuring
accrued market discount in chapter 1
under Market Discount
Bonds.
Disallowed interest expense.
In the year you dispose of the bond, you can deduct the amount of
any interest expense you were not allowed to deduct in earlier years.
Choosing to deduct disallowed interest expense before the
year of disposition.
You can choose to deduct disallowed interest expense in any year
before the year you dispose of the bond, up to your net interest
income from the bond during the year. The rest of the disallowed
interest expense remains deductible in the year you dispose of the
bond.
Net interest income.
This is the interest income (including OID) from the bond that you
include in income for the year, minus the interest expense paid or
accrued during the year to purchase or carry the bond.
Deferral of interest deduction for short-term obligations.
If the current income inclusion rules discussed in chapter 1
under
Discount on Short-Term Obligations do not apply to you, the
amount you can deduct for interest expense you paid or accrued during
the year to buy or carry a short-term obligation is limited.
The interest is deductible only to the extent it is more than:
- The amount of acquisition discount or OID on the obligation
for the tax year, plus
- The amount of any interest payable on the obligation for the
year that is not included in income because of your accounting method
(other than interest taken into account in determining the amount of
acquisition discount or OID).
The method of determining acquisition discount and OID for
short-term obligations is discussed in chapter 1
under Discount
on Short-Term Obligations.
Disallowed interest expense.
In the year you dispose of the obligation, or if you choose, in
another year in which you have net interest income from the
obligation, you can deduct the amount of any interest expense you were
not allowed to deduct for an earlier year. Follow the same rules
provided in the earlier discussion under Deferral of interest
deduction for market discount bonds.
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.
For more information about the capital gains rates, see
Capital Gain Tax Rates in chapter 4.
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.
Example.
Your 8-year-old son has interest income of $2,000, which you choose
to report on your own return. You enter $2,000 on lines 1a and 4 of
Form 8814 and $600 on line 6 of Form 8814 and line 21 of Form 1040.
Your investment income includes this $600.
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.
Example.
Your 10-year-old child has interest and dividend income of $4,000,
including $500 in Alaska Permanent Fund dividends. You choose to
report this on your return. You enter $4,000 on line 4 of Form 8814
and $2,600 on line 6 of Form 8814 and line 21 of Form 1040. You figure
the amount of your child's income that you can consider your
investment income as follows:
$2,600 - ($2,600 x ($500 x
$4,000)) |
= |
$2,275 |
Child's capital gain distributions.
If your child has capital gain distributions, fill out the
following worksheet before completing Form 4952.
Worksheet
(Keep for your records)
1. |
Enter amount from Form 8814, line 3 |
|
2. |
Enter amount from Form 8814, line 4 |
|
3. |
Divide line 1 by line 2 |
|
4. |
Base amount |
$1,400 |
5. |
Subtract line 4 from line 2 |
|
6. |
Multiply line 5 by the decimal on line 3. Enter
the result here. Also include it in figuring the amounts to enter on
lines 4b and 4c of Form 4952. |
|
7. |
Subtract line 6 from line 5. Enter the result
here. Also include it on line 4a of Form 4952. |
|
Example.
Your 9-year old daughter has ordinary dividends of $1,360 and a
$340 capital gain distribution from a mutual fund. You choose to
report this income on your tax return. On Form 8814, you enter $1,360
on line 2, $340 on line 3, $1,700 on line 4, and $300 on line 6. Then
you fill out the worksheet above. The amount on line 7 of the
worksheet ($240) is investment income, which you include on line 4a of
Form 4952. The amount on line 6 of the worksheet ($60) is included on
lines 4b and 4c of Form 4952. You must decide whether to make the
choice to include this $60 in investment income on line 4e.
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:
- The investment expenses included on line 22 of Schedule A
(Form 1040), or
- The amount on line 26 of Schedule A.
See Expenses of Producing Income, later, for a
discussion of the 2% limit.
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
for information about passive activities.
Example.
Ted is a partner in a partnership that operates a business.
However, he does not materially participate in the partnership's
business. Ted's interest in the partnership is considered a passive
activity.
Ted's investment income from interest and dividends is $10,000. His
investment expenses (other than interest) are $3,200 after taking into
account the 2% limit on miscellaneous itemized deductions. His
investment interest expense is $8,000. Ted also has income from the
partnership of $2,000.
Ted figures his net investment income and the limit on his
investment interest expense deduction in the following way:
Total investment income |
$10,000 |
Minus: Investment expenses (other than
interest) |
3,200 |
Net investment income |
$6,800 |
Deductible investment interest expense for the
year |
$6,800 |
The $2,000 of income from the passive activity is not used in
determining Ted's net investment income. His investment interest
deduction for the year is limited to $6,800, the amount of his net
investment income.
Form 4952
Use Form 4952, Investment Interest Expense Deduction, to
figure your deduction for investment interest.
Example.
Jane Smith is single. Her 2000 income includes $3,000 in dividends
and a net capital gain of $9,000 from the sale of investment property.
She incurred $12,500 of investment interest expense. Her other
investment expenses directly connected with the production of
investment income total $980 after applying the 2% limit on
miscellaneous itemized deductions on Schedule A (Form 1040).
For 2000, Jane chooses to include all of her net capital gain in
investment income. Her total investment income is $12,000 ($3,000
dividends + $9,000 net capital gain). Her net investment income is
$11,020 ($12,000 total investment income - $980 other investment
expenses).
Jane's Form 4952 is illustrated at the end of the chapter. Her
investment interest expense deduction is limited to $11,020, the
amount of her net investment income. The $1,480 disallowed investment
interest expense is carried forward to 2001.
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 do not have any other deductible investment
expenses.
- You have no carryover of investment interest expense from
1999.
If you meet all of these tests, you can deduct all of your
investment interest.
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