An interest-ing investment deduction
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In general, the tax code views passive activities as those in which you do not, in the words of the IRS, "materially participate" in the investment. So wouldn't earnings from stocks or mutual funds, for example, be passive since the investor has no direct control of the company actions that affect its stock value? No. The IRS defines this as investment income.

Owning a rental property, however, is a passive activity, "even if you're actively running and managing the property," says Rosenberg. And you can't claim the investment-interest deduction if the money is related to a passive activity.

Don't worry. You still get some tax advantages from the rental property, and the rent it generates, by filing Schedule E. You just can't claim it as investment interest.

Property flipping possibilities
What about property owned by investors who neither lived in the home nor turned it into a rental? They simply purchased the property and then flipped it soon thereafter for a profit.

Since these investors will owe taxes on the properties they turn over, they are invariably looking for ways to shave a few dollars off the IRS bill.

"If you hold a property solely for the purpose of appreciation, the interest from a loan to purchase that property could be deducted as investment interest against other investment income," says Hockenberry.

But, says Rosenberg, "that's a dumb way to handle the property."

"You get no depreciation. You can't deduct property taxes. The interest on the loan is only deductible against investment income; it will be sitting there mostly useless until you sell and can claim capital gains.

"Say you have a $200,000 property and are lucky and only pay $10,000 in interest on it," says Rosenberg. "If you don't have that much investment income, much of it [the deductible interest] is wasted until you sell."

Investment interest limits
While the investment interest deduction works well in many cases, as Rosenberg's example points out, the tax break does have its limitations.

You can only deduct investment interest against investment income, meaning money produced by your investments. Unlike capital losses that you can use to offset ordinary income, there is no such crossover for this deduction.

The good news: Your investment income doesn't have to come from the property you took out the loan to buy. It can be any investment income.

"These are such things as capital gains income, interest income from savings and investment accounts," says Hockenberry. You can even count your children's investment income if you report those earnings on your personal tax return.

The investment income, however, cannot come from tax-free investments, such as municipal bonds. Since you're already getting a tax benefit here, you can't double dip by using the asset's income to write off your investment-interest amounts.