Special at-risk rules apply to most income-producing activities. These rules limit the amount of loss you can deduct to the amount you risk losing in the activity. Generally, this is the amount of cash and the adjusted basis of property you contribute to the activity. It also includes money you borrow for use in the activity if you are personally liable for repayment or if you use property not used in the activity as security for the loan. For more information, see Publication 925.

The amount of losses and tax credits you can claim from passive activities is limited. Generally, you are allowed to deduct passive activity losses only up to the amount of your passive activity income. Also, you can use credits from passive activities only against tax on the income from passive activities. There are exceptions for certain activities, such as rental real estate activities.

A passive activity generally is any activity involving the conduct of any trade or business in which you do not materially participate and any rental activity. However, if you are involved in renting real estate, the activity is not a passive activity if both of the following are true.

The term trade or business generally means any activity that involves the conduct of a trade or business, is conducted in anticipation of starting a trade or business, or involves certain research or experimental expenditures. However, it does not include rental activities or certain activities treated as incidental to holding property for investment.

You are considered to materially participate in an activity if you are involved on a regular, continuous, and substantial basis in the operations of the activity.

Generally, you can use losses from passive activities only to offset income from passive activities. You generally cannot use passive activity losses to offset your other income, such as your wages or your portfolio income. Portfolio income includes gross income from interest, dividends, annuities, or royalties that is not derived in the ordinary course of a trade or business. It also includes gains or losses (not derived in the ordinary course of a trade or business) from the sale or trade of property (other than an interest in a passive activity) producing portfolio income or held for investment. This includes capital gain distributions from mutual funds and real estate investment trusts.

You cannot use passive activity losses to offset Alaska Permanent Fund dividends.

Do not include in the computation of your passive activity income or loss:

However, this interest and other expenses may be subject to other limits. These limits are explained in the rest of this chapter.

For more information about determining and reporting income and losses from passive activities, see Publication 925.

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).

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

If you receive debt proceeds in cash, the proceeds are generally not treated as investment property.

If you deposit debt proceeds in an account, that deposit is treated as investment property, regardless of whether the account bears interest. But, if you withdraw the funds and use them for another purpose, you must reallocate the debt to determine the amount considered to be for investment purposes.

If you receive loan proceeds in cash or if the loan proceeds are deposited in an account, you can treat any payment (up to the amount of the proceeds) made from any account you own, or from cash, as made from those proceeds. This applies to any payment made within 30 days before or after the proceeds are received in cash or deposited in your account.

If you received the loan proceeds in cash, you can treat the payment as made on the date you received the cash instead of the date you actually made the payment.

As you repay a debt used for more than one purpose, 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.

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.

For more information about allocating interest expense, see chapter 5 of Publication 535.

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.

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.

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:

Figure the amount in (2) above using the rules for figuring accrued market discount in chapter 1 under Market Discount Bonds.

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.

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.

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.

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 method of determining acquisition discount and OID for short-term obligations is discussed in chapter 1 under Discount on Short-Term Obligations.

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.

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.

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 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. Include it on line 4a of Form 4952.

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 of interest and dividend income on lines 1a and 2 of Form 8814. Subtract the result from the amount on line 6 of Form 8814.

If part of the amount you report is your child's capital gain distributions, that part (which is reported on line 13 of Schedule D or line 13 of Form 1040) generally does not count as investment income. However, you can choose to include all or part of it in investment income, as explained in Choosing to include net capital gain, earlier.

Your investment income also includes the amount on line 6 of Form 8814 (or, if applicable, the amount figured under Child's Alaska Permanent Fund dividends, earlier).

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

See Expenses of Producing Income, later, for a discussion of the 2% limit.

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.

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

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

Bond premium is the amount by which your basis in the bond right after you get it is more than the total of all amounts payable on the bond after you get it (other than payments of qualified stated interest). For example, a bond with a maturity value of $1,000 generally would have a $50 premium if you buy it for $1,050.

In general, your basis for figuring bond premium amortization is the same as your basis for figuring any loss on the sale of the bond. However, you may need to use a different basis for convertible bonds, bonds you got in a trade, and bonds whose basis has to be determined using the basis of the person who transferred the bond to you. See section 1.171–1(e) of the regulations.

A dealer in taxable bonds (or anyone who holds them mainly for sale to customers in the ordinary course of a trade or business or who would properly include bonds in inventory at the close of the tax year) cannot claim a deduction for amortizable bond premium.

See section 75 of the Internal Revenue Code for the treatment of bond premium by a dealer in tax-exempt bonds.

Figure the bond premium amortization for each accrual period as follows.

Your yield is the discount rate that, when used in figuring the present value of all remaining payments to be made on the bond (including payments of qualified stated interest), produces an amount equal to your basis in the bond. Figure the yield as of the date you got the bond. It must be constant over the term of the bond and must be figured to at least two decimal places when expressed as a percentage.

If you do not know the yield, consult your broker or tax advisor.

You can choose the accrual periods to use. They may be of any length and may vary in length over the term of the bond, but each accrual period can be no longer than 1 year and each scheduled payment of principal or interest must occur either on the first or the final day of an accrual period. The computation is simplest if accrual periods are the same as the intervals between interest payment dates.

To do this, multiply your adjusted acquisition price at the beginning of the accrual period by your yield. Then subtract the result from the qualified stated interest for the period.

Your adjusted acquisition price at the beginning of the first accrual period is the same as your basis. After that, it is your basis decreased by the amount of bond premium amortized for earlier periods and the amount of any payment previously made on the bond other than a payment of qualified stated interest.

For special rules that apply to variable rate bonds, inflation-indexed bonds, and bonds that provide for alternative payment schedules or remote or incidental contingencies, see section 1.171–3 of the regulations.

Under this method, the amount of your bond premium amortization is the same each month. Divide the number of months you held the bond during the year by the number of months from the beginning of the tax year (or, if later, the date of acquisition) to the date of maturity or earlier call date. Then multiply the result by the bond premium (reduced by any bond premium amortization claimed in earlier years). This gives you your bond premium amortization for the year.

Under this method, the amount of your bond premium amortization increases each month over the life of the bond. This method is explained in Revenue Ruling 82–10.

If the amount of your bond premium amortization for an accrual period is more than the qualified stated interest for the period, you can deduct the difference as a miscellaneous itemized deduction on line 27 of Schedule A (Form 1040).

But your deduction is limited to the amount by which your total interest inclusions on the bond in prior accrual periods is more than your total bond premium deductions on the bond in prior periods. Any amount you cannot deduct because of this limit can be carried forward to the next accrual period.

Generally, if you first elected to amortize bond premium before 1998, the above treatment of the premium does not apply to bonds you acquired before 1988.

The amortization of the premium on these bonds is a miscellaneous itemized deduction not subject to the 2%-of-adjusted-gross-income limit.

The amortization of the premium on these bonds is investment interest expense subject to the investment interest limit, unless you choose to treat it as an offset to interest income on the bond.

You can deduct attorney or accounting fees that are necessary to produce or collect taxable income. However, in some cases, attorney or accounting fees are part of the basis of property. See Basis of Investment Property in chapter 4.

A bank may offer its checking account customers an automatic investment service so that, for a charge, each customer can choose to invest a part of the checking account each month in common stock. Or, a bank that is a dividend disbursing agent for a number of publicly-owned corporations may set up an automatic dividend reinvestment service. Through that service, cash dividends are reinvested in more shares of stock, after the bank deducts a service charge.

A corporation in which you own stock also may have a dividend reinvestment plan. This plan lets you choose to use your dividends to buy more shares of stock in the corporation instead of receiving the dividends in cash.

You can deduct the monthly service charge you pay to a bank to participate in an automatic investment service. If you participate in a dividend reinvestment plan, you can deduct any service charge subtracted from your cash dividends before the dividends are used to buy more shares of stock. Deduct the charges in the year you pay them.

You can deduct office expenses, such as rent and clerical help, that you pay in connection with your investments and collecting the taxable income on them.

To replace your taxable securities that are mislaid, lost, stolen, or destroyed, you may have to post an indemnity bond. You can deduct the premium you pay to buy the indemnity bond and the related incidental expenses.

You may, however, get a refund of part of the bond premium if the missing securities are recovered within a specified time. Under certain types of insurance policies, you can recover some of the expenses.

If you receive the refund in the tax year you pay the amounts, you can deduct only the difference between the expenses paid and the amount refunded. If the refund is made in a later tax year, you must include the refund in income in the year you received it, but only to the extent that the expenses decreased your tax in the year you deducted them.

You can deduct fees you pay to a broker, bank, trustee, or similar agent to collect investment income, such as your taxable bond or mortgage interest, or your dividends on shares of stock.

You cannot deduct a fee you pay to a broker to acquire investment property, such as stocks or bonds. You must add the fee to the cost of the property. See Basis of Investment Property in chapter 4.

You cannot deduct any broker's fees, commissions, or option premiums you pay (or that were netted out) in connection with the sale of investment property. They can be used only to figure gain or loss from the sale. See Reporting Capital Gains and Losses, in chapter 4, for more information about the treatment of these sale expenses.

You can deduct fees you pay for counsel and advice about investments that produce taxable income. This includes amounts you pay for investment advisory services.

You can deduct rent you pay for a safe deposit box if you use the box to store taxable income-producing stocks, bonds, or other investment-related papers and documents. If you also use the box to store tax-exempt securities or personal items, you can deduct only part of the rent. See Tax-exempt income under Nondeductible Expenses, later, to figure what part you can deduct.

You cannot deduct the state and local transfer taxes you pay when you buy or sell securities. If you pay these transfer taxes when you buy securities, you must treat them as part of the cost of the property. If you pay these transfer taxes when you sell securities, you must treat them as a reduction in the amount realized.

If you set up a revocable trust and have its income distributed to you, you can deduct the commission you pay the trustee for managing the trust to the extent it is to produce or collect taxable income or to manage property. However, you cannot deduct any part of the commission that is for producing or collecting tax-exempt income or for managing property that produces tax-exempt income.

If you are a cash-basis taxpayer and pay the commissions for several years in advance, you must deduct a part of the commission each year. You cannot deduct the entire amount in the year you pay it.

If you hold an interest in a partnership, S corporation, real estate mortgage investment conduit (REMIC), or a nonpublicly offered regulated investment company (mutual fund), you can deduct your share of that entity's investment expenses. A partnership or S corporation will show your share of these expenses on your Schedule K–1. A nonpublicly offered mutual fund will indicate your share of these expenses in box 5 of Form 1099–DIV, or on an equivalent statement. Publicly-offered mutual funds are discussed later.

If you hold an interest in a REMIC, any expenses relating to your residual interest investment will be shown on line 3b of Schedule Q (Form 1066). Any expenses relating to your regular interest investment will appear in box 5 of Form 1099–INT or box 7 of Form 1099–OID.

Report your share of these investment expenses on Schedule A (Form 1040), subject to the 2% limit, in the same manner as your other investment expenses.

Your share of the investment expenses of a REMIC or a nonpublicly offered mutual fund, as described above, are considered to be indirect deductions through that pass-through entity. You must include in your gross income an amount equal to the amount of the expenses allocated to you, whether or not you are able to claim a deduction for those expenses. If you are a shareholder in a nonpublicly offered mutual fund, you must include on your return the full amount of ordinary dividends or other distributions of stock, as shown in box 1 of Form 1099–DIV or an equivalent statement. If you are a residual interest holder in a REMIC, you must report as ordinary income on Schedule E (Form 1040) the total amounts shown on lines 1b and 3b of Schedule Q (Form 1066). If you are a REMIC regular interest holder, you must include the amount of any expense allocation you received on line 8a of Form 1040.

Publicly-offered mutual funds, generally, are funds that are traded on an established securities exchange. These funds do not pass investment expenses through to you. Instead, the dividend income they report to you in box 1 of Form 1099–DIV is already reduced by your share of investment expenses. Therefore, you cannot deduct the expenses on your return.

Include the amount from box 1 of Form 1099–DIV in your income.

You cannot deduct transportation and other expenses that you pay to attend stockholders' meetings of companies in which you have no interest other than owning stock. This is true even if your purpose in attending is to get information that would be useful in making further investments.

You cannot deduct expenses for attending a convention, seminar, or similar meeting for investment purposes.

You cannot deduct interest on money you borrow to buy or carry a single-premium life insurance, endowment, or annuity contract.

If you use a single premium annuity contract as collateral to obtain or continue a mortgage loan, you cannot deduct any interest on the loan that is collateralized by the annuity contract. Figure the amount of interest expense disallowed by multiplying the current interest rate on the mortgage loan by the lesser of the amount of the annuity contract used as collateral or the amount of the loan.

Generally, you cannot deduct interest on money you borrow to buy or carry a life insurance, endowment, or annuity contract if you plan to systematically borrow part or all of the increases in the cash value of the contract. This rule applies to the interest on the total amount borrowed to buy or carry the contract, not just the interest on the borrowed increases in the cash value.

You cannot deduct expenses you incur to produce tax-exempt income. Nor can you deduct interest on money you borrow to buy tax-exempt securities or shares in a regulated investment company (mutual fund) that distributes only exempt-interest dividends.

The rule disallowing a deduction for interest expenses on tax-exempt securities applies to amounts you pay in connection with personal property used in a short sale or amounts paid by others for the use of any collateral in connection with the short sale. However, it does not apply to the expenses you incur if you deposit cash as collateral for the property used in the short sale and the cash does not earn a material return during the period of the sale. Short sales are discussed in chapter 4.

You may have expenses that are for both tax-exempt and taxable income. If you cannot specifically identify what part of the expenses is for each type of income, you can divide the expenses, using reasonable proportions based on facts and circumstances. You must attach a statement to your return showing how you divided the expenses and stating that each deduction claimed is not based on tax-exempt income.

One accepted method for dividing expenses is to do it in the same proportion that each type of income is to the total income. If the expenses relate in part to capital gains and losses, include the gains, but not the losses, in figuring this proportion. To find the part of the expenses that is for the tax-exempt income, divide your tax-exempt income by the total income and multiply your expenses by the result.

If you itemize your deductions, you can deduct, as taxes, state income taxes on interest income that is exempt from federal income tax. But you cannot deduct, as either taxes or investment expenses, state income taxes on other exempt income.

You cannot deduct interest and carrying charges that are allocable to personal property that is part of a straddle. The nondeductible interest and carrying charges are added to the basis of the straddle property. However, this treatment does not apply if:

For information about straddles, including definitions of the terms used in this discussion, see chapter 4.

Interest includes any amount you pay or incur in connection with personal property used in a short sale. However, you must first apply the rules discussed in Short Sale Expenses under Short Sales in chapter 4.

To determine the interest on market discount bonds and short-term obligations that are part of a straddle, you must first apply the rules discussed under Deferral of interest deduction for market discount bonds and Deferral of interest deduction for short-term obligations (both under Interest Expenses, earlier).

Figure the nondeductible amount of interest and carrying charges on straddle property as follows.

Add the nondeductible amount to the basis of your straddle property.

If you use an accrual method, you cannot deduct interest and other expenses owed to a related cash-basis person until payment is made and the amount is includible in the gross income of that person. The relationship, for purposes of this rule, is determined as of the end of the tax year for which the interest or expense would otherwise be deductible. If a deduction is denied under this rule, this rule will continue to apply even if your relationship with the person ceases to exist before the amount is includible in the gross income of that person.

This rule generally applies to those relationships listed in chapter 4 under Related Party Transactions. It also applies to accruals by partnerships to partners, partners to partnerships, shareholders to S corporations, and S corporations to shareholders.

The postponement of deductions for unpaid expenses and interest under the related party rule does not apply to original issue discount (OID), regardless of when payment is made. This rule also does not apply to loans with below-market interest rates or to certain payments for the use of property and services when the lender or recipient has to include payments periodically in income, even if a payment has not been made.