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Similarly, you can't count earnings
in your retirement accounts. "That interest is either deferred
in a traditional account or tax-free in a Roth," says Hockenberry.
You also are not allowed to deduct more in interest
payments than you earned. For example, let's say you took a loan
to buy Google stock and paid $1,000 in interest on it. If your total
investments produced only $800, that's the maximum investment interest
you can deduct.
You can carry the excess interest ($200 in this example)
into future tax years and deduct it against those earnings. There
is no limit on how long you can carry forward and use up the interest.
When you carry forward the deduction, you'll have to file Form 4952
along with your Form 1040 and Schedule A, where you list your interest-deduction
amount.
You also need to evaluate whether taking the investment-interest
deduction is the right tax move for your situation.
Some dividend payments and capital
gains are taxed at lower rates (15 percent for most filers).
If you count any of these earnings in order to take the investment
interest deduction, you must pay the ordinary
tax rates (potentially as much as 35 percent) on the earnings.
So be sure to run the numbers before you decide.
Follow the money
If you find that the investment-interest deduction might help you,
keep in mind the cardinal rule for all tax transactions: Maintain
good records so you can justify your deduction if the IRS asks.
The IRS isn't particularly concerned about the source
of the loan. What it wants to know is how the loan progressed from
the lender to your investment.
"If you borrowed on margin because you needed
money to pay personal bills, that's not investment interest,"
says Rosenberg. "But if you borrowed money from your own home
and directly used that money to make an investment, that's going
to be investment interest.
"The money has to be directly related to an investment.
If you borrowed money from some other source and used it to buy
investments, you have to trace the money.
"That's what IRS will do, trace the money trail."
Rosenberg recommends that you put the borrowed funds
into a separate account or have the loan check made out directly
to the company from which you're going to buy the investment. This
will clearly show your investment intention. It also could help
prevent unintended transactions that could invalidate your deduction.
"If you put [the loan money] in your bank
account, and other checks clear, say your mortgage payment or other
bills, before the check to make the investment clears, then you're
going to have to deduct those personal amounts and associated interest
from the loan money before you can claim it toward investment income,"
says Rosenberg.
Freelance writer Kay Bell writes
Bankrate's tax stories from her home
in Austin, Texas, and blogs on tax topics at Don't
Mess with Taxes.
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