More than 20 years ago, taxpayers found that the various interest charges they paid on everything from mortgages to credit card balances to auto loans provided them a bit of a tax break. They could deduct that interest when they filed their returns.
Most interest deductions disappeared in 1986, when lawmakers overhauled the tax code. Now, the only remaining interest write-offs are for amounts paid on mortgage, student and investment loans.
While millions still claim the mortgage-interest deduction every year, the investment-interest break is generally overlooked. But for some filers, it could provide additional tax savings.
What counts as investment interest?
The first step to claiming this deduction is to determine whether you have, in the eyes of the Internal Revenue Service, investment interest.This deduction is typically used by people who borrow money to buy stocks, bonds and other equities. Others buy investments on margin; that is, they borrow money from their broker to make purchases. The amount paid on that margin account is investment interest.
But the deduction can be used for other investments. And this is where it gets tricky.
"People don't understand what it means," says Cindy Hockenberry, a practicing enrolled agent and member of the National Association of Tax Professionals research staff in Appleton, Wis. "It's basically any interest you incur to buy any investment, not just stocks or bonds."
Interest paid on a loan to purchase land, for example, could qualify for the deduction. So could, under the right circumstances, interest you pay on a loan you took out to invest in a privately held company, says Eva Rosenberg, a California-based enrolled agent and the Web's TaxMama.
Investing in real estate
However, if the lot you purchased has a house on it, the availability of the investment-interest deduction gets more complicated, since the tax code contains varying rules when it comes to real estate.Your primary residence gets the benefits of many tax breaks, including the popular mortgage-interest deduction. A mortgage on a second home is also eligible for the interest write-off, as long as loans on both houses don't exceed $1 million. You also need to make sure you use the second house enough for it to qualify as a personal vacation retreat.
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Go beyond these two holdings, and you'll find the tax treatment of real estate decidedly different.
When you own rental property, the IRS classifies that as a passive investment, says Rosenberg. "The passive rules are so complicated, even IRS auditors can't figure them out," she says, only partially in jest.