Limits on Deductible Interest

The general rule is that you may deduct interest on investment-related loans, up to the amount of your investment income for the year. If you paid more interest than the income you received, you can carry over the disallowed portion of the income to later years, when you can offset it by other investment income.

Your allowable deduction for investment interest is calculated on IRS Form 4952, Investment Interest Expense Deduction. You must complete this form and attach it to your return unless all of the following are true:

• Your only investment income was from interest or dividends; that is, you had no annuity or royalty income, no rental income from nondepreciable property, no equity-financed lending activities, and no interests in partnerships or LLCs licensing intangible property. In counting investment income, you must include investment income reported to you by any partnerships or S corporations on a K-1, by an estate or trust, or your child's investment income that you elected to report on your own return.
• You have no other deductible expenses connected with the production of interest or dividends.
• Your investment interest is less than or equal to your total investment income.
• You have no carryover interest deductions from previous years.

Financial Calculators Use this Loan & Credit Line Tax Savings Calculator to determine your tax savings on loans or credit lines with tax deductible interest payments.

If even one of the previous statements is not true, you must complete Form 4952. Luckily, this form is relatively simple. It will ask you to add up your investment income, subtract any deductible investment expenses, and then subtract interest payments up to the remaining investment income.

In adding up your investment income, we mentioned above that you can include investment income of a child, if you opted to report that child's income on your own return. There's another option to consider. You can, if you want, include some or all of your capital gains for the year, including any capital gains distributions from mutual funds. However, if you do, your deductions will offset those gains and you will lose the benefit of the special, lower tax rate on capital gains.

Save Money If you're expecting to have significantly more investment income in later years, you may be better off not including the capital gains so that you get the benefit of the lower capital gains tax rate this year. Instead, carry over the interest deduction to next year, so it offsets more of your ordinary income at higher tax rates.

In subtracting your deductible investment expenses on this form, you only need to subtract the expenses you will actually be able to deduct; that is, expenses that exceed 2 percent of your adjusted gross income (AGI). If your itemized deductions are limited because your AGI is very high include only investment expenses that are left, after the limit is applied.

The total amount of allowable investment income is transferred from Form 4952 to Line 14 of Schedule A, Itemized Deductions.