Margin Interest Deduction Has Its Limits

If you purchase stocks on margin you have what the IRS calls Investment Interest. Investment interest is deductible on your 1040 as an itemized deduction. However, there are stringent limits as to the amount of investment interest may be deducted in any one year.

The investment interest deduction is figured on IRS Form 4952. The basic rule is that the investment interest deduction is limited to net investment income. And, according to IRS rules, investment income is very narrowly defined. Basically, investment income includes interest income and dividend income, but not qualified dividends or capital gains. You can elect to include qualified dividends and capital gains as investment income, but, it you do, then the qualified dividends and capital gains are no longer taxed at the advantageous capital gains tax rates, but at ordinary income tax rates.

The next step, once investment income is determined, is to determine net investment income. Net investment income is simply investment income minus investment expenses.

Investment expenses are expenses, other than interest, directly connected with the production of investment income. An example of an investment expense might be a subscription to the Wall Street Journal. The only investment expenses taken into account are those that exceed 2 percent of a taxpayer’s Adjusted Gross Income and used as a Miscellaneous Deduction on Schedule A.

Once net investment income is known, then the amount of investment interest eligible to be deducted is automatically known. For example, if you have $1,200 in margin interest, and your net investment income is $900, then your investment interest deduction is $900. This amount is carried from the form 4952 to Line 13 of Schedule A.

Investment Interest that cannot be used in any particular year can be carried forward indefinitely until it can be used. For example, investment interest in excess of net investment income for 2007 may be carried forward to 2008 and it will be deductible in 2008 to the extent that when added 2008 investment interest expenses it does not exceed net investment income. If not used in 2008, the carryforward extends indefinitely to 2009 and future years.