Interest paid to carry investment property is aptly named investment interest expense. Investment interest expense is deductible to the extent of your investment income.
Investment income is current income from dividends, interest and gains from properties that produce dividends and interest. Investment interest expense is an ordinary income tax deduction. Because qualified dividends and long-term capital gains are taxed at preferential rates, you can only count them as investment income if you elect to forgo their favorable tax rates. An interest expense you cannot deduct currently because of the income limitation is disallowed and available to be carried forward indefinitely until you have investment income to offset.
For example, if you pay $10,000 a year in interest but only have $1,000 in investment income, the remaining $9,000 is carried forward to the subsequent tax year. If you pay $10,000 again in the next year and have the same income, you carry forward $18,000 in investment interest expense. That is the $9,000 disallowed from year one and the $9,000 from year two.
Use Internal Revenue Service Form 4952 to claim investment interest expense and also to elect to forgo the favorable tax rates on qualified dividends and long-term capital gains. Also, see my prior article, "Deducting taxes on unimproved land," for information about electing to capitalize expenses relating to unproductive real property.
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