Investment interest is interest on money you borrow specifically for buying property you hold for investments that yield taxable income. This includes (among other things) stocks, non-tax-exempt bonds, and land or other investment property. This doesn't include straddles or anything that yields tax-exempt income (such as municipal bonds, life insurance, or annuities).
If the loan on stock comes from a broker, it is usually referred to as a margin account. If you used part of a home equity loan (or line of credit) to buy the investment, the interest on that loan doesn't count toward investment interest if it qualifies to be deducted as home mortgage interest. Also, investment interest doesn't include any interest related to a passive activity.
If you borrow money and use only part of it for investment purposes, then you must allocate the interest between the various uses. The allocation is based on how much of the loan is used for each purpose.
Example: You borrow $10,000, and use 20% ($2,000) of it for investments and 80% ($8,000) to pay off your credit cards. In the first year of the loan, you pay a total of $600 in interest. Of the $600 you paid, $120 (20%) of it is investment interest. The rest of the interest ($480) isn’t deductible.
Generally, you can't deduct interest that you haven't paid. That may seem obvious, but if you know how much interest you will be paying, you can't deduct that interest even if it applied to a loan you had during the year.
Example: You took some money out of your margin account in November (2010), and plan to pay off the loan by the end of February (2011). By the end of (2010), 2 months of interest will have accrued, but because you haven't paid the interest, you can't deduct it. When the loan is paid off in February (2011), you'll receive a statement from your broker reporting the margin interest you received. Because you'll be reporting this income on your (2011) tax return, you'll be able to deduct the interest at that time based on the investment interest deduction rules. Note: Prepaid interest (interest that hasn't yet accrued) is also generally not deductible.
There are rules that limit the amount of investment interest you can deduct. The amount of investment interest that you can deduct can't be more than the amount of net investment income that you report. For purposes of this deduction, net investment income is defined as interest, dividends, short-term capital gains, royalties, and so forth, reduced by investment expenses. Generally, you can't include qualified dividends or long-term capital gains as investment income because you're already getting a tax break on them since they're taxed at a lower rate (0% or 15% depending on your tax bracket) than ordinary income.
However, if you designate qualified dividends or long-term capital gains as investment income when you prepare your taxes, you can include this amount in the calculation of net investment income. Once you decide to do this, however, you can't take advantage of the lower tax rates that qualified dividends and long-term capital gains usually receive. They will now be taxed at the same rate as all your other income. The advantage of making this election is that you'll be able to deduct more investment interest. However, if you decide not to allocate any of the qualified dividends or long-term gains to ordinary income, you can carry over any investment interest expense that you couldn't use. You need to decide which option will give you the least amount of tax liability.
Example: You have investment interest expense of $2,400. Your net investment income consists of interest of $1,300, qualified dividends of $750, and long-term capital gains of $2,000. The total amount you can deduct is $1,300, ignoring the qualified dividends and the long-term capital gains. You have $1,100 of remaining investment interest. You can choose to have $1,100 of the qualified dividends and long-term capital gains treated as investment income. If you do it, you’ll have a deduction of $2,400, but only $1,650 will be taxed at the reduced rates for qualified dividends and long term capital gains.
You deduct investment interest on Schedule A with your other itemized deductions. To deduct investment interest, you’ll need to file a Form 4952 with your return. On this form, you calculate the amount of investment interest that you can deduct, as well as the amount to be carried over to future years (if any). Also, this is where you designate the amount of qualified dividends and long-term capital gains that you want to treat as investment income.
For more information, see IRS Publication 550, Investment Income and Expenses.